Discount rate

Last updated: 17.03.2016

Discount rate is the rate of return (interest rate) used in discounted cash-flow calculations. Most often, it is cost of capital, but other rates are also possible.

Discount rate can be:

  • cost of capital, most often WACC – the most common discount rate
  • specified minimum target rate of return (so called hurdle rate)
  • rate of return on alternative investment opportunity
  • company overall ROCE/ROI – compared to WACC it allows for more risks and discount rate is therefore higher
  • current or future expected market interest rate (30)

The higher is the discount rate, the lower NPV will be achieved and it is less probable that the project will be accepted.

The right choice of discount rate depends on the purpose. To decide whether the investment project will add value, WACC will be sufficient. Rate of return on alternative investment opportunity may be appropriate when deciding between mutually exclusive projects. (30)

 

With respect of the inflation covered, discount rate can be either:

  • nominal (money)
  • real

 

Nominal discount rate includes inflation and can be derived by Fisher equation as:

(1 + real discount rate) * (1 + inflation rate) – 1  

 

There are two possibilities how to incorporate inflation to NPV calculation:

  1. Using nominal future cash-flows (i.e. cash-flow is related to future period price level and is therefore expressed in values that already incorporate inflation) and discounting them with nominal discount rate.
  2. Using real cash-flows (i.e. cash-flow is related to the starting period price level and therefore does not consider inflation) and discounting them with real discount rate. (31)

 

 With respect of the income tax rate covered, discount rate can be either:

  • pre-tax
  • post-tax

If relevant cash-flows in the calculation include the tax effects, after-tax discount rate shall be used.

 

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The sources:

30. Net present value (online).  Citation date: 19.1.2016. Available from www: https://en.wikipedia.org/wiki/Net_present_value

31. Obaidullah Jan, ACA, CFA. NPV and inflation (online). Citation date: 19.1.2016. Available from www: http://accountingexplained.com/managerial/capital-budgeting/npv-and-inflation



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