The Discount Rate – essential for any Finance course worth its title, pivotal for valuation, capital budgeting, and a whole host of other concepts. But what is a discount rate? And why exactly does it matter? Let’s find out.
Money loses value over time. This fact is called the time value of money.
When it comes to companies determining whether they should invest in something, they’d need to consider 3 things:
- time value of money
- firm specific risk (or project risk), and
- market risk (aka Systematic Risk)
All these 3 factors are elegantly and beautifully incorporated into a tiny little number called the discount rate.
Now, whether you’re new to this concept or you’re in need of a refresher, we’ll explain the discount rate in-depth, including why it’s important.
We’ll also briefly get into often-confused alternative definitions so you know the difference.
What is a Discount Rate?
Firstly, what is a discount rate?
As the name kinda suggests, it’s a rate.
It’s a rate that’s used to discount the future value of cash flows and put it in terms of present value.
The discount rate is sometimes also known as the “hurdle rate.” More on this further down, but let’s get some jargon out of the way so we’re all on the same page.
Jargon Buster
As with most things in Finance, there are a multitude of other synonyms/terms, including:
- required rate
- cost of capital
- opportunity cost of capital
- cost of equity (for a particular type of discount rate)
- cost of debt (for a particular type of discount rate)
- WACC (again, for a particular type of discount rate)
We’ll touch on these synonyms and other ‘types’ of discount rates further down.
For now, let’s think about how the discount rate actually works.
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How Does the Discount Rate Work?
Companies are always investing money into new ventures.
However, a successful company won’t do this until they understand how much the investment is estimated to be worth in the future.
Typically, this is done by calculating the future value of cash flows.
But that cannot and shouldn’t be the only means to evaluate a project’s feasibility and worthiness.
Since most of the costs of actually starting a new investment often come in the early phases, companies need to understand how much money the investment will cost.
And then compare it with the estimated cash flow it will generate in the future (expressed in today’s terms).
In other words, they need to compare the initial investment with the present value of future cash flows.
Put differently, they need to calculate the Net Present Value of project.
Ideally, the cost of the investment is less than the future cash flow expressed in today’s terms.
In other words, ideally, the investment is a positive NPV one.
And this is where the discount rate comes in.
How Does the Discount Rate Affect the Time Value of Money?
Like we said at the start of this article, money loses value over time.
This fact is called the Time Value of Money.
Money largely loses value because of the effects of inflation. And this is incorporated into the discount rate by the risk-free rate.
Since money is usually in a state of inflation, it’s important to understand that a $10,000 investment today is not worth the same as a $10,000 investment back in say, 1980.
Future cash flows are discounted at the discount rate (by dividing them by 
) to reflect this loss in value as well as other risks.
What Types of Discount Rates Are There?
The discount rate is used for a variety of purposes, including (but not limited to):
- investment appraisal and capital budgeting
- bond valuation
- stock valuation / company valuation
- estimating expected returns (e.g., using the CAPM)
While all these concepts/purposes rely on a discount rate, it’s not necessarily the same discount rate.
Different discount rates are necessary for different circumstances.
We’ll explain five of the most-used types of discount rates, including:
- hurdle rate
- cost of debt
- cost of equity
- weighted average cost of capital (WACC)
- risk-free rate
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Hurdle Rate
Although this is mostly used for internal projects a business might need to analyze for feasibility, individuals could potentially use it to examine their own investments. The idea’s to invest in projects/investments where the rate of return is greater than the hurdle rate.
Cost of Debt
Companies take on debt all the time to finance corporate projects. If taking on debt is necessary for a project, understanding what that debt will cost is just as important as the estimated cash flows of the project that debt is funding. Borrowing is only feasible if the rate of return is greater than the cost of debt.
Cost of Equity
Sometimes, rather than funding a project with debt, a company will fund it by offering equity (stock) to investors. The same principle applies here as for the cost of debt – a project/investment is only worthwhile if the rate of return is greater than the cost of equity.
Weighted Average Cost of Capital (WACC)
Since some projects are funded by both debt and equity, this rate helps put the total cost of a company’s capital into perspective. It is weighted based on how much of each category of capital / source of finance (i.e., debt, equity, etc.) the company carries.
Risk-Free Rate
Rather different from the other rates above, the risk-free rate is the interest rate investors can earn assuming a theoretical zero risk to the investment. This is usually a government-issued bond since governments are the least likely to default on their debts. The risk-free rate is often used to incorporate the effects of the time value of money.
How To Calculate the Discount Rate
Most businesses have plans written down that define the minimum rate of return an investment needs to provide before it will be viable.
This is their hurdle rate, which could either be set as a rule of thumb, or estimated from scratch.
In order to figure out the discount rate, a company’s finance department would need to figure out whether the project is fairly standard in terms of risk (in which case a rule of thumb may be okay).
Or if it represents a much higher risk or is completely different to existing projects, in which case a custom/unique discount rate is likely more appropriate.
As a general rule of thumb however, the discount rate one uses should be a function of which source of capital we use to fund the project.
If the project/investment is funded by Debt only, use the Cost of Debt.
If instead, the project/investment is funded only by Equity, then use the Cost of Equity.
Lastly, if the project/investment is funded by Debt and Equity, then use the Weighted Average Cost of Capital (WACC).
Cost of Equity
The cost of equity discount rate can be estimated by using the Capital Asset Pricing Model as:
![\[k_e = r_f + \beta(r_m - r_f)\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-a87dc45bc2ff385659fb855457da6231_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Where:
refers to the Cost of Equity
reflects the Beta (aka Systematic Risk or Market Risk)
denotes the risk-free rate
reflects the Beta (aka Systematic Risk or Market Risk)
denotes the risk-free rateThis isn’t the only way, though.
One could also estimate the cost of equity using the dividend yield as:
![\[k_e = \frac{Div_{t+1}}{P_t}\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-f58173931922760f0861d006b13ff82b_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Cost of Debt
The discount rate / cost of debt for debt-funded projects can simply be the rate of interest on the loan as:
![\[k_d = \frac{\$I}{D}\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-e677890153e2a7a7132c294c525620c1_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Where:
refers to the dollar value of interest paid
reflects the market value of debt
refers to the dollar value of interest paid
reflects the market value of debtAlternatively, one could use the CAPM with a debt Beta as:
![\[k_d = r_f + \beta_D (r_m - r_f)\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-2f652bff13812236db42548938705c17_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Here, all the notations are identical to the Cost of Equity formula (
) above, but 
reflects the Beta of Debt instead of just “Beta”.
Weighted Average Cost of Capital (WACC)
If the project/investment is funded by debt and equity, then the appropriate discount rate is the Weighted Average Cost of Capital (WACC).
And the WACC formula can be expressed as:
![\[WACC = k_e \left(\frac{E}{D+E}\right) + k_d \left(\frac{D}{D+E}\right)\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-468f578880b0c01876185da66ee051a4_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Where:
- refers to the Cost of Equity
reflects the Cost of Debt- reflects the market value of Debt
- denotes the market value of Equity
reflects the Cost of Debt
denotes the market value of EquityNote that strictly speaking, this is the WACC formula when there is no tax.
If a company operates in a country where taxation exists, then the WACC formula is…
![\[WACC = k_e \left(\frac{E}{D+E}\right) + k_d(1-t_c) \left(\frac{D}{D+E}\right)\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-50b51e80271fab20cc1b3d2b86a7b510_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
Here, the notations are identical to the WACC formula above. The only new item is 
, which reflects the corporation tax rate.
Alternative WACC Formula
Alternatively, we could express the WACC formula like this:
![\[WACC = k_e \left(\frac{E}{V}\right) + k_d(1-t_c) \left(\frac{D}{V}\right)\]](https://www.ferventlearning.com/wp-content/ql-cache/quicklatex.com-873d0bacd795f49f98f27061d63e1779_l3.svg?495a33&495a33 "Rendered by QuickLaTeX.com")
The only thing that’s changed is the denominator.
We’ve gone from 
to just 
.
That’s because reflects the value of the firm, which in turn is nothing but Debt + Equity (per the accounting equation).
We could write a whole other article on the WACC alone.
The context here is the discount rate in general, however.
But the important thing to understand with the WACC is that it allows for a weighted estimate of the cost of capital.
And its weight is influenced by three things, including:
- the proportion of equity finance
- the proportion of debt finance, and
- the tax rate
Okay, now that you know what the discount rate is and how to calculate the discount rate, let’s think about some common confusion.
Common Confusion with the Discount Rate
People often get mixed up with the discount rate vs the interest rate and “cost of capital”.
We hope that the Jargon Buster above has made it clear that, for the most part, you can think of them as interchangeable terms.
Let’s now think about why that is true.
Discount Rate vs Interest Rate
The discount rate is actually an interest rate, but it’s specific to calculating the present value or future value of money on an investment.
Think about the cost of debt example above. We said that we can estimate it as the rate of interest on the loan:
It’s less intuitive to see this when you consider the cost of equity or the WACC as a whole.
However, it’s still fair to say that the discount rate is a kind of interest rate.
From a practical standpoint, we tend to use the word “discount rate” when we’re discounting future cash flows.
And we tend to use the word “interest rate” when we’re compounding present cash flows into the future.
Discount Rate vs Cost of Capital
As we’ve discussed, the cost of capital could be expanded to the Weighted Average Cost of Capital (WACC) (or cost of equity, cost of debt, depending on the source of capital).
Most companies keep a very close eye on this figure and use it as a guide to not only calculate the present value of future cash flows but also to figure out if they’re paying too much for their capital.
Alternatively, the discount rate is used to verify the feasibility of a new project. Sometimes, the WACC is used as the discount rate in cash flow calculations.
However, if the project is riskier than normal for the company, the discount rate might need to be higher. This will effectively build in a bigger financial buffer in the event the estimated cash flows come out lower than expected.
Final Thoughts: The Discount Rate
The discount rate is an important metric in any new project that a business might want to consider.
This is because many projects on the corporate level take years to start generating positive net cash flows.
The discount rate allows companies to understand the future value of an investment in terms of its present value.
This allows a company then to decide if the future cash flows are enough to justify the initial investment requirement (by estimating the NPV, for example).
It’s an extremely useful figure that can be used in a number of ways, including (but not limited to) stock valuation, bond valuation, project appraisal, etc.
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