Did you ever think of running your own business? For a while, let’s suppose you are the CEO of an ABC Corporation. It is a SaaS company that is growing exponentially. At this point, you are thinking of pitching to investors.
So, you will first have to make your company an attractive prospect for investors. How can you do that? The answer is – by finding your discount rate.
However, you must keep in mind that as a business, evaluating the discount rate could be a complicated task. The discount rate is essential for investors and companies assessing the future.
An accurate discount rate is integral to reporting, investing, and evaluating the financial viability of projects in the company. So, without further ado, let’s find out more about discount rate and their relevant information in this post.
What is Discount Rate?
The discount rate meaning is the interest rate used to discover the Net Present Value (NPV) of a project’s future cash flows. NPV assists in determining the profitability of a project or an investment. Thus, the interest rate helps comprehend whether the project is going to be viable or not.
Every investor or company anticipates specific future cash flows when agreeing to an investment or a project. But such future cash flows cannot be regarded as such to comprehend the project’s feasibility.
The reason is the decrease in the money’s value over time. Moreover, there is risk or uncertainty about the future, which must also be considered.
Hence, companies oversee a Discounted Cash Flow (DCF) analysis. Such an analysis uses discounting to evaluate the project’s current value based on its future cash flows. In simple words, it allows investors to comprehend the project’s NPV.
A positive NPV discount rate means that the present value of the cash flow is more than the initial investment cost. This means that returns are greater than the costs. Hence, it states that the project is viable. So, investing would be a correct decision.
How to Calculate Discount Rate?
The discount rate formula can be articulated as future cash flow divided by present value. And then, it is raised to the number of years’ reciprocal and minus one.
You can use the following steps to derive the formula for the discount rate:
Step 1: First and foremost, comprehend the value of your future cash flow that is under consideration.
Step 2: And then find out the present value of the future cash flows.
Step 3: Next, you will have to find the number of years between the present day and the time of the future cash flow. Denote this time by n
Step 4: Lastly, the discount rate formula can be taken by dividing Step 1 (future cash flow) by Step 2 (the present value) and raising to Step 3 (reciprocal of the number of years) and the minus one.
Mathematically speaking, it will be presented as:
Discount Rate = (Future Cash Flow / Present Value)^ 1/n – 1
Here,
n = number of years
If multiple compounding is involved during a year (t), the discount rate formula will be:
Discount Rate = T * [(Future Cash Flow / Present Value) 1/t*n – 1]
Types of Discount Rate
For companies, the future value of a specific investment doesn’t amount to anything. They can evaluate the worthiness of investment only based on its current value. Thus, the discount rate turns out to be a handy metric for assessing the present value.
Different companies choose different rates. For example, some may use the return rate they wish to get from investments based on the risks involved. Others may use the Weighted Average Cost of Capital (WACC) discount rate.
Thus, different rates apply to investments based on the purpose or the nature for which they are used. Jotted down below is more information about types of discount rates.
- WACC
It is a significant rate of return that the investors of a company expect in return for the capital. It is helpful to evaluate the company’s equity value.
- Risk-free Rate
It is the rate of return on a specific investment with no related risks. This rate helps in evaluating the time value of money.
- Cost of Equity
The Cost of Equity is the return rate a company pays to the equity shareholders. It is generally used to evaluate the equity value of an organization.
- Hurdle Rate
It is referred to as the minimum acceptable rate of return for investing somewhere. This rate helps assess investments in internal corporate projects.
- Cost of Debt
The cost of Debt is the interest rate a company pays to the bondholders. It is used for the valuation of assets that produce fixed income.
Discount Rate Example
To understand the discount rate in more detail, let’s take an example here:
Suppose there is an organization called XYZ Corporations. It must receive a future cash flow worth Rs.5000 after five years. Now, let us calculate the discount rate if the present value of that future cash flow is Rs.2500.
The discount rate will be calculated with the help of this formula:
Discount Rate = (Future Cash Flow / Present Value) ^ 1/ n – 1
= (5000 / 2500) ^ 1/5 – 1
= 14.87%
Thus, in this situation, the discount rate used to compute the present value is 14.87%.
Conclusion
At last, understanding the future cash flows and their value by comprehending your discount rate is crucial. It is even more vital to determine the possible risk factors and value for new developments or projects. You would only wish to move ahead with such investments that offer more revenue than the initial costs.
Thus, being familiar with your discount rate is essential to know where your cash flow is standing in the forthcoming years. This will help you determine whether a specific investment or project is worthy of your attention and efforts.
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