How to calculate a discount rate

Discounting is a method of determining the future value of the cash flows, i.e. a reduction of amount of future revenues to the present time. In order to properly assess their value, it is necessary to know the predicted values of revenue, expenses, investments, capital structure and rate of discounting, i.e. the rate of return on invested capital.

Instruction

Most often, the rate of discounting is determined as the weighted average cost of capital. Using this method you will get the most objective result. For the calculation of the discount use the following formula:WACC = Re(E/V) + Rd(D/V)(1-Tc), гдеRe – rate of return on equity (cost of equity), %;E is the market value of equity;D – market value of debt capital;V – the total value of borrowed capital and shares of the company (equity);Rd – rate of return of borrowed capital (cost of capital);Tc is the tax rate on profits.

The rate of discounting of equity capital you can calculate as follows:Re = Rf + b(Rm-Rf), гдеRf – nominal risk-free rate of return;Rm – the average rate of return on the stock market;(Rm-Rf) – market risk premium;b is a coefficient showing the change in the share price of the company in comparison with changes in stock prices in this segment of the market. In countries with a developed stock market the ratio is calculated by the specialized research agencies.

However, note that this approach allows to calculate rate of discount is not for all businesses. It does not apply to companies that are not open joint-stock companies, i.e. do not trade shares in the market. In addition, it can not use firms that have no data to calculate its b–factor. In these cases, enterprises should apply another method of calculating the rate of discounting.

Cumulative evaluation method the risk premium is based on two assumptions. First, if the investment was risk-free, investors would require a risk-free return on their capital. Second, the higher the capital owner assesses project risk, the higher the demands it makes on the profitability. On this basis, the rate of discounting is determined as follows:R = Rf + R1 +..+Rn, гдеRf – nominal risk-free rate of return;R1..Rn is the risk premium on the various factors.The presence of each factor and their value is set by experts. This method is more subjective, since the value of the risk premium depends on the personal opinion of the expert.

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