Discount Rate: What is it? How to estimate the right value for it?

By Trader Pit

July 5, 2021


As a trader, you may have two tools that are vital to evaluating the performance of a security: the option chain and the risk-free rate. The option chain represents your options position and the risk-free rate is what’s needed to estimate the value of the option chain.

The Discount Rate is a pretty important economic variable. In order for a company to survive, it has to be able to make money. And the cost of doing so is the cost of borrowing money. So, let’s say a company has a $100 million long-term debt. Now, let’s say that interest rates are at 10%. That means that for every dollar that the company gets in profit, it has to pay back $10. Simple, right?

The discount rate is the interest rate charged by a bank to a borrower for a loan. It is a crucial part of the capital structure of the business and is used by the bank to assess what the loan is worth to them. It is always calculated as a percentage of the amount of money borrowed.. Read more about what is the discount rate and let us know what you think.The discount rate is nothing more than the expected minimum return on the investment. The term discount rate is used to calculate the present value of future cash flows of an investment.

Why should the present value be calculated? This is a method of determining whether an investment is profitable or not. How do you do that? This can be done in three steps.

The first step is to estimate future cash flows. The second step is to estimate the appropriate discount rate (minimum expected return). The third step is the calculation of the present value.

In all three steps, it is important to correctly estimate the discount rate. Only then will the correct current value appear.

Particular attention is paid to the estimation of future cash flows and the calculation of the present value. But the discount rate is ignored. It’s not that important.

The purpose of this article is to reveal the concept of discount rate. This allows choosing the appropriate discount rate for investment analysis.

Watch the video: The concept of discount rate

Draft discount rate

It is possible to carry out an investment assessment from the perspective of two people. The first is a small investor and the second is a businessman. The two individuals will have a different understanding of the discount rate for their investment analysis. Let’s see why.

Investor

As we have seen, the discount rate is nothing but the expected minimum return. Before making the investment, an investor has two options. He can either invest in a risk-free option or invest elsewhere. Check out the infographic below to understand the mindset of investors.

The risk-free option offers the investor a minimum return. Therefore, it becomes its discount rate. The investor will then use this discount rate to analyze the present value of other investments (e.g., stocks and real estate).

Businessman

It’s harder for a businessman to make investment decisions. A venture capital transaction only makes sense if the return exceeds the cost of capital (WACC). Check out the infographic below to understand the businessman’s mindset.

The cost of capital (WACC) can be calculated as the proportion of equity and debt capital in the total capital required to start a business. How can these costs be covered? It will go bankrupt (profit).

The WACC is a kind of profit margin that a company must achieve in order to stay afloat. So it becomes the businessman’s discount rate. This rate is then used to analyze the present value of all estimated future cash flows of the entity.

Let’s understand this better with the help of a video and some examples.

Examples of discount rates

To better understand the concept of the discount rate, we take an example and evaluate it from two perspectives. First, an investor and second, a businessman.

#1. Investor outlook

In this example, we consider an investment where one sum of money is invested to buy shares. The shares will generate future cash flows in the form of dividends over five years and capital gains in the fifth year.

For this investment, we need to make a value analysis to see if it is worth investing in. How do you do that? First of all, we need to create a link. This link will be our safe bet.

One of the easiest ways to choose a risk-free rate is to check the performance of a 5-star bond fund over the past 5 years. In the current environment (post-covids), our risk-free return would be about 7.5% per year.

Now we can do two (2) things:

First

We can calculate the present value of future cash flows using a discount rate of 7.5% per annum. To calculate the current value, we can use the PV formula in Excel.

In our example, using a discount rate of 7.5%, the total present value of future cash flows would be Rs. 1,28,743. This value is higher than the invested value of Rs 1,00,000 crore, which means that the cash flows at least meet the minimum criterion of 7.5%. That’s good.

Second

We have to iterate to determine at what discount rate the total present value of all future cash flows would be Rs 1,00,000 crore (corresponding to the amount invested).

I did this iteration. It was found that at 13.237% per year the total present value becomes equal to the invested amount.

What does that mean? This indicates that if the current cash flows are maintained, the maximum return that these investments can generate is 13,237% per annum.

#2. The businessman’s perspective

Let’s look at the same example from a business perspective. Suppose a company needs Rs 1,00,000 crore as capital. By investing this capital (in land, buildings, other assets), the company will generate the following cash flow (profit) over the next 5 years:

The capital structure of this company consists of 60% equity and 40% bank loans. The expected return to shareholders (equity) from this investment is 16,062 % per year and the interest on the loan is 9,02 % per year. The weighted average cost of capital (WACC) for this company would therefore be 13.24% (=60% x 16.062% + 40% x 9.0%).

A WACC of 13.24% would be the discount rate for analyzing the company’s future cash flows. How is the analysis performed? By calculating the present value (PV) of future cash flows using Excel’s PV formula.

If the total calculated PV is greater than or equal to the invested capital (Rs. 1,00,000), it means that the business enterprise can be considered. Here is the PV work calculated in Excel:

What conclusion can we draw from these figures? This shows that if the company generates the cash flows shown over the next five years, it will be able to maintain a weighted average cost of capital (WACC) of 13.24%.

Supplement

To better understand the usefulness of the discount rate, the reader should also become familiar with the concept of present value. That’s a whole other problem. But at this point we must remember that no present value calculation (value investment) can produce the right figures without the right discount rate.

Remember that estimating the discount rate is a science in itself. But this does not prevent us from starting from a number that is at least approximately correct for him. How do you do that? That’s exactly what this article is about.

I hope you enjoyed the examples (first and second) and the video explaining the topic.

Leave your comments in the section below.A discount rate is a very important concept in finance. It is used to estimate the present value of a series of cash flows. The discount rate is a very important part of an investor’s decision-making process. It helps investors determine how much they should be willing to pay for a given amount of cash flow. Some investors even use the discount rate to determine the “price” of a security.. Read more about discount rate calculator and let us know what you think.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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