A business valued at a future price means nothing to an investor. A business needs to be valued at the present value to make it relevant. So how does one arrive at the present value? The future cash flows of the business are discounted at a rate to arrive at the present value. This rate is rate of interest or cost of capital employed. Another perspective indicates discount rate is nothing but the investors expected rate of return. The cash flows are discounted at a rate which is usually the weighted average cost of capital (WACC).
As a practice we always discount the projected cash flows to a present value to arrive at the intrinsic value of business.
What are the reasons for discounting the cash flows?
1) Time Value of Money:
First, we need to understand the time value of money. The value of money in future will be much less than what it is today. This means that what Rs 1000 can purchase today, it won’t be able to purchase the same in future, under the given rate of inflation. Suppose you earn Rs 1 lac per month and if someone tells you salary would be Rs 2 lacs per month after 5 years, should you be too happy? You will need to first check the value of those Rs 2 lacs in today’s light. Similarly, for a business or bond, it is important to check the value in today’s term.
Discounting is the opposite of growing. While compounding means making the invested money grow at a particular interest rate, discounting means bringing the increased sum back to the present value.
2) Riskiness of the future
The aim of discount rate is to factor in for the loss of money of an investor due to underlying risks. The cash flow is discounted so as to compensate for the losses that can happen to an investment. However, many choose to discount the cash flows with a risk adjusted discount rate: Eg: In long gestation projects like real estate, construction of bridge or oil drilling, there uncertainty relating to future market conditions, inflation levels and other economic risks. The discount rate is therefore adjusted for risk based on the expected liquidity of the company, credit risk, market risk etc. For international projects, one has to consider exchange rate risk and as well as geographical risk.
Example: A project requiring a capital outflow of Rs 115,000 will return a cash inflow of Rs 150,000 in three years. A company can also invest the fund in a different project that will earn 8%, so this rate is used as the discount rate.
The present value factor in this case will be ((1 + 8%)³), or 1.259. Therefore, the present value of the future cash flow is (Rs 150,000/1.259), or Rs 119074.84. Since the present value of the future cash is more than the current cash outflow, the project brings in a net cash inflow, hence the project should be accepted.
However, if the discount rate is adjusted for risk, the outcome will be different. Suppose this project is in an overseas country with a volatile exchange rate. Therefore, the discount rate is adjusted to 10%, which means that a company can get this rate from projects of similar risk profile. The present value interest factor is now ((1 + 10%)³), or 1.331. Therefore, the new present value of the cash inflow is (Rs 150,000/1.331), or $112697. When the discount rate was adjusted to factor in additional risks pertaining to the project, it resulted in lower cash inflows than the capital expenditure. Hence, the investor would not opt for this project.
Various types of discount rate:
(1) Cost of equity
Net Present Value or NPV is the resultant of the present value of cash inflows minus the present value of cash outflows. It is used as a capital budgeting tool to assess the viability of a long term project. A positive NPV means better returns, hence a profitable project, while a negative NPV means cash outflows, which means an investment option best avoided. NPV uses the Time Value of money into consideration. It compares the value of a rupee today to the value of that same rupee in the future, considering inflation and returns. The discount rate used to arrive at this is the cost of equity. The cash flows that are considered are the cash flows to equity holders.
(2) WACC (Weighted average cost of capital)
In the discounted cash flow analysis, the discount rate is the cost of capital from all sources, including equity, bonds and long-term debt. The weightage applied to the cost of equity and cost of equity is the weight of the equity and debt, respectively, in the capital structure. Eg:
E= Equity, D=Debt, V= Market value of the firm (Equity+Debt), Re=Return on Equity, Rd=Cost of debt, Tc=Tax rate
Most of the companies use WACC as the cost of capital because it is the minimum return required by the companies. As a rule companies should invest only in projects that generate returns more than WACC.
(3) Interest rate of the bond
As per the traditional approach of bond valuation, the single cash flows are discounted at the appropriate interest rate. This rate of interest used to discount the bond’s cash flows is called the yield to maturity (YTM.) The YTM (Yield to Maturity) is the annualized return of the bond which is purchased today and held to maturity.
Discount rate is an important concept in the field of valuation and understanding its basics will make financial modeling a much easier exercise.