The discount rate is the main input of a discounted cash flow analysis. I put that in nearly every single financial model you see on the site as well as have standalone templates just for performing DCF analysis work. What people always ask is how to come up with the right discount rate to enter in to the model. Let's dive in.
Relevant Templates:
When it comes to defining a discount rate for a business opportunity, there are several methodologies you can consider. The choice of methodology depends on various factors such as the nature of the opportunity, the industry, and the risk profile. Here are some commonly used methodologies:
- Weighted Average Cost of Capital (WACC): WACC is a widely used approach that considers the cost of both debt and equity capital. It reflects the average rate of return required by all stakeholders, including investors and lenders. The WACC is calculated by weighting the cost of equity and the after-tax cost of debt according to their proportion in the capital structure.
- Capital Asset Pricing Model (CAPM): CAPM is a method that calculates the expected return on equity by considering the risk-free rate of return, equity risk premium, and beta of the investment opportunity. Beta measures the sensitivity of the investment's returns to the overall market fluctuations.
- Build-Up Method: The build-up method involves adding various risk premiums to the risk-free rate of return. These risk premiums may include an equity risk premium, a size premium, an industry-specific risk premium, and a company-specific risk premium. The specific risk premiums are determined based on the characteristics of the business and the industry.
- Comparable Company Analysis: This method involves looking at similar companies or transactions in the market and analyzing the discount rates used for those opportunities. Comparable company analysis helps in identifying the appropriate discount rate based on market trends and investor expectations.
- Modified Internal Rate of Return (MIRR): MIRR adjusts the discount rate to account for the reinvestment rate of the cash flows. It assumes that positive cash flows are reinvested at a certain rate and negative cash flows are financed at a different rate. The MIRR aims to address the potential issues with the traditional Internal Rate of Return (IRR) method.
- Scenario-based Analysis: In this approach, you consider multiple scenarios with different discount rates to evaluate the potential range of outcomes. Each scenario reflects a different level of risk or uncertainty associated with the opportunity. By assigning appropriate discount rates to each scenario, you can assess the sensitivity of the investment's returns to changes in risk levels.
In my opinion, the WACC is the best way to figure out what your discount rate should be.
The WACC is a calculation that incorporates both the cost of debt and the cost of equity, weighted by their respective proportions in the capital structure. Here's an example of how to calculate the WACC:
1. Determine the proportion of debt and equity in the company's capital structure:
Let's assume the company has $5 million in debt and $15 million in equity, resulting in a debt-to-equity ratio of 1:3.
2. Calculate the cost of debt:
Determine the interest rate the company pays on its debt or can obtain for new debt issuance. For example, if the interest rate on the debt is 6%, the cost of debt would be 6% * (1- tax rate) * 6%). Notice we don't want to forget to adjust this for tax benefits. You want to reduce the cost of debt by the tax benefit by doing (1-tax rate) * weighted average interest rate. If the tax rate is 25%, then you simply multiply 6% * 0.75% = 4.5%.
3. Calculate the cost of equity:
Use the capital asset pricing model (CAPM) or other suitable methods to estimate the cost of equity. Let's assume the risk-free rate is 3%, the market risk premium is 8%, and the company's beta is 1.2. Applying the CAPM formula:
Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 3% + 1.2 * 8% = 12.6%
Note, in the above calculation, the 8% is calculated by taking the expected return of the market less the risk free rate. So, in this case the market return average would be 11%. The market risk premium is just telling an investor how much they should expect to earn above the risk free rate in the open market.
4. Determine the weights of debt and equity:
Calculate the proportion of debt and equity in the capital structure. In this example, the weights would be 1/4 (debt) and 3/4 (equity).
5. Calculate the WACC:
WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)
WACC = (1/4 * 4.5%) + (3/4 * 12.6%) = 10.575%
In this example, the WACC is 10.575%. This rate can be used as the discount rate to evaluate the present value of future cash flows associated with the business opportunity.
Article found in Valuation.
