Disambiguation: this article is referring to a discount rate (i.e. as applied in DCF analysis) rather than the discount rate (i.e. the Federal Reserve short-term loan interest rate).
You may remember from earlier blogs that when exploring Net Present Value and the Time Value of Money, a crucial element of the calculation was a “discount rate”, but what exactly is that? In this blog post we’ll explore what they are, the different types, why they matter, how they relate to familiar economic principles such as opportunity costs, how to calculate them and how businesses factor them into appraising potential investment opportunities.
What is a discount rate?
A discount rate (also known as “the opportunity cost of capital”) represents the Time Value of Money, the risk associated with a project and the opportunity cost of tying up capital in a specific project. It is the figure we use to calculate the present value of future cash flows of a project or the amount of money we would need today to earn a certain value in the future, and is often used as the minimum rate a project must return for it to be considered a viable investment.
Why do discount rates matter?
As we discussed in the Time Value of Money blog, a dollar today is worth more than a dollar received in the future, so being able to quantify this is a key part of both Net Present Value (NPV) calculations and Discounted Cash Flow (DCF) analysis, when both evaluating a standalone potential project, and comparing different projects, particularly if they are of varying lengths or different risk profiles. A higher discount rate means that there is either a higher level of risk associated with the project (to ensure that the project generates sufficient returns to compensate for the perceived increased risk) or a higher opportunity cost of capital (i.e. alternative projects could return higher returns if they were invested in instead).
What types of Discount Rate are there?
Weighted Average Cost of Capital (WACC)
This is the average rate across all capital sources (e.g. debt, bonds, stock etc) that a company expects to pay when financing its business and is often used as a discount rate by businesses when evaluating potential projects
Hurdle rate
Similar to the WACC but whereas the WACC focuses more on the company’s overall cost of capital, the hurdle rate is more project-specific - so it features an additional premium to account for risk - and is the minimum rate that a company has set that must be met before they are willing to invest in that specific project.
Risk-free Rate of Return
This is the interest rate on an investment that has zero chance of failing - usually the three-month US Treasury bill as it is guaranteed by the US government - and is often used as a discount rate when investing in standard assets, such as treasury bonds.
Risk-free Rate of Return + Risk Premium
As the name suggests, this takes the risk-free rate above, then adds a premium to account for additional risk, and is often used as a discount rate for equity investors.
In terms of which rate to use, this depends on the purpose, the risk profile, financing structure, etc of the project.
How is a discount rate calculated?
To calculate the discount rate we use the following formula:
dr = ( ( FV / PV ) ^ ( 1 / ( n * t ) ) ) - 1
where:
dr = discount rate
FV = future value
PV = present value
t = the number of years
n = the number of compounding periods per year
Example
In the previous example we saw that with $10,000 compounded monthly, after three years the Future Value was $10,617.84, so to solve for the discount rate we take those numbers and put them into our equation:
r = ( ( 10,617.84 / 10,000 ) ^ ( 1 / ( 12 * 3 ) ) ) - 1
= 0.0016667
then multiply by 100 to convert to a percentage
0.0016667 * 100
= 0.16667
and finally, multiply by 12 to convert to an annual rate
0.16667 * 12
= 2%
and we are back to the 2% discount rate that we originally saw.
Summary
As we have seen, without a discount rate companies would be extremely limited in their ability to evaluate projects or compare potential projects, which is why the Discount Rate is one of the configurable and easily adjustable options in every Business Case and Project within the our platform, which automatically recalculates Net Present Value (NPV), Return on Investment (ROI) and Discounted Payback Period.
To see how you can start realizing value with KangaROI, reach out and schedule a demo today.
