What is a Discount Rate and How to Calculate it?
The discount rate is the rate of return that is used in a business valuation.
The discount rate is the rate of return, and is used in business valuations of a company in converting a series of future anticipated cash flows to the present value of the business using the discounted cash flow method. Confused? Well, let us assume that you are the founder of a company and are looking for some investors. The first thing that you need to do is make your company attractive to investors. And that is done by determining your discount rate.
Nonetheless, getting the discount rate as a business can be very complicated. The discount rate is the main metric when positioning for the future for investors and companies. Due to this, getting an accurate discount rate is crucial to reporting and investing, and also for assessing the financial viability of new projects within the company.
Based on the content, the discount rate has two different definitions and uses. First, the discount rate is the interest rate used in the discounted cash flow (DCF) analysis to get the present value of cash flows in the company. Second, the discount rate is used as an interest rate charged to the financial institutions for loans that they get from the Federal Reserve Bank via the window discount loan process.
But here we are going to focus on the first kind of discount rate overall in the article since founders need to know about this when getting an investment for their business.
What is Discount Rate?
The discount rate is the rate of return that is used in a business valuation. It is used to convert future anticipated cash flow from the company to present value using the discounted cash flow approach (DCF). One of the common methods to derive the discount rate is by using a weighted average cost of capital approach (WACC). This approach represents a weighted average of after-tax costs of debt in the company along with the cost of equity. The weighting here is based on the target debt-equity ratio of the company, which is measured at the market rate.
To be specific, the discount rate is a term that is used to find the business value and is usually confused with the capitalization rate. But they are different since the capitalization rate is used with the single discretionary cash flow, but the discount rate is used with a series of cash flows of a forecast. So, the discount rate of the company is linked to the amount of risk in the operation and the ability to access the capital of the company.
And even though the discount rates for each company can be very different, it is crucial for business owners to comprehend that discount rates would normally fall under the following ranges:
Note: The following is just an idea of how much it would be for a company, but it can vary so do take professional help and use the right formula
- 30%+ for startups: These deals are mostly with venture capital firms.
- 26% – 30% for businesses with revenue between $5 million and $50 million: Such companies usually have a much higher risk with limited debt capacity.
- 21% – 25% for businesses with revenue between $50 million and $500 million. Companies in this range usually carry a risk of the product, customer, or geographic concentration and access to capital are challenging in this case too.
- 16% – 20% for businesses with revenue between $500 million to $1 billion: They have modest risk profiles. Small public companies or large private companies come under this discount rate range.
- 10% – 15% for businesses (MNCs) with revenues greater than $1 billion: Obviously, these are multinational corporations (MNCs) such as Microsoft and Apple, and have a low risk. They also have access to large amount of debts.
So, if you are about to get a valuation of your company done based on the discount rate using the discounted cash flow approach, and your discount rate is higher or lower than those shared above, then choose another method. Keep on reading to understand things better.
Why is a Discount Rate used?
From the definition, you might have understood what the discount rate is. The discount rate is used for investors and companies to see how far they will reach in the future. This is used for companies to understand their future cash flow values, which helps them keep their development within the budget. For investors, the discount rate helps them assess the feasibility of the investment based on the value-now and value-later of the company.
The discount rate formula is used in two places. It is used in the APV (adjusted present value) formula and WACC (weighted average cost of capital) formula.
- Using it to calculate the Net Present Value (NPV) – The discount rate is used in the calculation of the future cash flows of a business using the net present value of the company. It expresses the change in the value of the investment money in the company over time. In short, it is vital to get the NPV value if you are going to use the discounted cash flow method to get the value of the method and the discount rate helps in getting this value.
- Used by Federal Reserve Bank – The discount rate is also used by financial institutes for short-term loans offered to the company. This is very different and is not determined using the formulas shared here.
Net Present Value or NPV
To get the discount rate of your business, you need to calculate the company’s future cash flows. This cash flow is determined using your company’s net present value, which is also called the NPV. The discount rate would express the change in the value of money that is being invested in your business over time. So, you need to know the NPV when you are using the discounted cash flow method to get your company’s value. This method is one of the most common methods that investors use to decide if they need to invest in your business.
In case the future cash flow of your company is a lot higher than the present value and your discount rate can show this, then this would attract investors even more to invest in your company. So, both the DCF and the NPV methods are used to get the value of the company by accessing the quality of an investment opportunity. And both these methods use the discount rate as their main element.
What is NPV?
To explain better, NPV is the difference between the present value of the cash inflows in the company and present cash outflows in the company over a period of time. The discount rate in NPV along with the time period concerned will affect the calculations of the NPV for your company. Basically, NPV is used to measure the costs, benefits, and main profitability of an investment over time. This formula takes into consideration inflation and returns. It features investment planning and capital budgeting. In fact, there is even a special Excel function for it.
Here is the NPV formula:
The discount rate in the NPV formula is used to get the difference between the value-return on an investment in the future and the money invested in the present. In this, the weighted average cost of capital (WACC, explained in the next section) is used as the discount rate when calculating the NPV. Even though this is used as such, sometimes it is thought to be more appropriate to use a higher discount rate to adjust for risk or opportunity cost.
Investors usually tend to use a particular figure as a discount rate based on their projected return. For example, in case the investment made is being utilized to target a specific rate of return. Then this return rate is used as the discount rate in the NPV calculation. All in all, NPV is the indicator of how much value a project or investment adds to the company.
Let us take an example to understand this. You, being the owner of a company, are asked to present the NPV of a project that needs some investment. Let us say that the investment asked for is $300,000. And with this investment, the company would be able to earn about $120,000 every year as the net cash flow of 5 years. And the target rate of return is 12%, which is the discount rate. In this case:
- NPV = $120,000 (year1) * 1/(1 + 0.12) + $120,000 (year 2) * 1/ (1 + 0.12)^2 ….=$432,573
- Then, $432,573 – $300,000=$132,573 or 44% return.
Here, it is clear that the NPV is not only positive but also very high. This means that the investor would happily go ahead with the investment and invest in your company. And this is exactly how you use the NPV and the discount rate to get the return value of your business.
How to Calculate Discount Rate?
There are two different discount rate formulas including – adjusted present value (APV) and the weighted average cost of capital (WACC). Both of these formulas are used a lot in the world of financing and each has been explained below. It will also help you understand how to calculate the discount rate with these formulas.
In fact, the discount rate utilized will depend on the kind of analysis used. Individuals should utilize the opportunity to invest their money to work in another place at an appropriate discount rate. To say this in a simple way, it is the rate of return that the investor earns in the marketplace on the investment of comparable risk and size. On the other hand, a business can use an opportunity cost-based discount rate. But they would also have to use the WACC, or they can use the historical average returns of the assets being analyzed. To understand more about the processes, each has been explained below:
Weighted Average Cost of Capital (WACC)
WACC is usually utilized to get the enterprise value of a company by looking into the cost of goods that the company has and that can be sold. These goods can include the bongs, stocks, inventory, and any other debts that the company has on its books. This value combines the after-tax cost of debt and the cost of equity. Then, the cost of each capital source, both equity and debt is multiplied by its relevant weight. All these values are then added together to get the WACC value.
Here is the WACC formula to calculate the discount rate in a company:
This discount rate formula can easily be altered to get the results of the periodic inventory. This is the cost of those goods that are available for sale and those available for sale even at the end of the sales period. It can also be altered to get the results of the perpetual inventory, which is the average before the sale of the units.
Let us take an example to understand this better. You have a company and it has taken off well. Now, you want to calculate the WACC to get the enterprise value. For this, let us say that the long-term debt (D) is at $2 billion for the year 2020 and the shareholder equity (E) will be $5 billion.
- The net capital = E + D = V = 5 billion + 2 billion = $7 billion
- The equity-linked cost of capital = (E/V) * Ce = 5/7 * 6.67% = 0.04764285714
- The debt component = (D/V) * Cd * (1+T) = 2/7 * 6.5% * (1-21%) = 0.01467142857
- WACC = 0.04764285714 + 0.01467142857 = 0.06231428571% ≐ 0.0623%
Adjusted Present Value (APV)
The second discount rate formula is used by getting the adjusted present value (APV). This formula also uses the NPV. APV analysis tends to be preferred in highly leveraged transactions since it is not as simple as the NPV valuation. In fact, this formula considers the benefits of raising debts such as the interest tax shield. This formula can also work perfectly when trying to reveal the hidden value of less practical investment possibilities. When there is an investment with a portion of the debt, a few prospects that didn’t look viable with NPV alone suddenly seem more attractive as investment opportunities.
In this discount rate formula, the calculation is quite simple and uses the cost of equity as the discount rate:
The discount rate is the main key to managing the relationship between a company and an investor. It is also a key to handle relationships with the company and its future. The health of the cash flow is very important for the company not just now, but also in the future as most of the startups rely on the cash flows of the company. And for an investor to invest in a startup can be a huge risk, which is why they need to know the value of the cash flows in the future of the company.
Furthermore, for you to manage your company’s expectations and to get a good investment for the company, you need to know how to get the right discount rate. This means that you will need to use the right discount rate formula and set the right rate relative to your inventory, debt, equity, and overall present value.
Cost of Capital vs Discount Rate
The discount rate and the cost of capital are two similar terms and are usually confused with one another. Although they are used to get the ultimate result that would help you decide if a new project or investment would be profitable or not, they are not the same and have some vital distinctions that make them different. Each has been explained below to help understand the difference between them:
- Cost of Capital – The cost of capital is the needed return that is important for making an investment or project worthwhile. This is focused more on the kind of funding that is used to pay for the project or investment. In case the funding is financed internally, then it refers to the cost of equity. And if it is financed externally, then it refers to the cost of debt.
- Discount Rate – The discount rate, on the other hand, is the interest rate that is utilized to determine the present value of future cash flows in a DCF analysis. With this, the company will be able to see if the future cash flows from the investment or project will be worth more than the capital expenses required to fund the project or investment in the present.
Get Your Business Valuation from Eqvista
Now that you know how valuation methods like these can help your business, it is time to use it. You can use the Eqvista business valuation calculator tool. But remember that if you need to get the valuation for giving out options and many other legal processes, it is important to get a professional to work on your company’s 409A valuation. This is a requirement as per the IRS so it is not something that you can avoid or ignore. Eqvista can help run your company’s 409a valuation by our team of certified professionals. Check out our valuation price list or contact us today!