How to calculate the discount rate

Discounting is a method of determining the future value of cash flows, i.e. bringing the amount of future income to date. In order to correctly evaluate their value, it is necessary to know the forecast values ​​of revenue, expenses, investments, capital structure and discount rate, i.e. rate of return on invested capital.

Instruction manual

1

Most often, the discount rate is defined as the weighted average cost of capital. When using this method, you will get the most objective result. To calculate the discount rate, use the following formula: WACC = Re (E / V) + Rd (D / V) (1-Tc), where Re is the rate of return on equity (cost of equity), %; E is the market value of equity; D - market value of borrowed capital; V - total cost of borrowed capital and company shares (equity); Rd - rate of return on borrowed capital (cost of borrowed capital); Tc - income tax rate.

2

You can calculate the discount rate for equity as follows: Re = Rf + b (Rm-Rf), where Rf is the nominal risk-free rate of return; Rm is the average rate of return on the stock market; (Rm-Rf) is the premium for market risk; b - a coefficient showing the change in the price of a company’s stock in comparison with changes in stock prices in this market segment. In countries with developed stock markets, this ratio is calculated by specialized analytical agencies.

3

However, keep in mind that this approach does not allow all businesses to calculate the discount rate. It does not apply to companies that are not open joint stock companies, i.e. Do not trade stocks on the market. In addition, it can not be used by companies that do not have data to calculate their b – coefficient. In these cases, enterprises should use a different method of calculating the discount rate.

4

The cumulative method of evaluating a risk premium is based on two assumptions. Firstly, if investments were risk-free, then investors would demand risk-free returns on their capital. Secondly, the higher the owner of the capital assesses the risk of the project, the higher the requirements for profitability. Based on this, the discount rate is determined as follows: R = Rf + R1 +.. + Rn, where Rf is the nominal risk-free rate of return; R1..Rn are the risk premiums for various factors. The presence of each factor and their value can be found by experts. This method is more subjective in nature, since the amount of the risk premium depends on the personal opinion of the expert.