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The Discount Rate Defined: Full Explanation and Excel Examples
In finance, the Discount Rate represents the expected or targeted annualized returns on an investment; to a company, it represents the cost of capital or minimum return required; to investors, it represents the opportunity cost.
The Discount Rate Defined: Full Explanation and Excel Examples
Discount Rate Definition: In finance, the Discount Rate represents the expected or targeted annualized returns on an investment; to a company, it represents the cost of capital or minimum return required; to investors, it represents the opportunity cost.
The Discount Rate can be specific to one group of investors (e.g., just the equity investors or common shareholders), or it can be for all the investors in a company or project.
We use the Discount Rate to calculate the Present Value of the future cash flows generated by a company or asset – in other words, what those future cash flows are worth to us today:
The time value of money tells us that money tomorrow is worth less than money today because we could invest the money today and earn more with it by tomorrow.
The Discount Rate lets us quantify this difference and compare different investment opportunities.
A higher Discount Rate indicates higher risk and greater potential upside, while a lower Discount Rate means lower risk and lower potential upside.
The Discount Rate has dozens of uses in finance, but for a simple example, consider whether you would invest in Google or Microsoft.
They’re both massive tech companies, and from a quick analysis, you believe their appropriate Discount Rate is approximately 10%.
In other words, by investing in a set of similar mega-cap tech companies, you could potentially earn a 10% annualized return over the long term.
This Discount Rate sets your expectations as an investor, but it doesn’t represent what you could earn by investing in just one specific company in this set.
To determine that, you need to project each company’s cash flows and possible valuation in the future.
From that analysis, you might determine that you could earn a 15% annualized return with Microsoft but only 12% with Google.
Therefore, both companies are viable investment candidates since both their expected returns exceed the Discount Rate.
However, Microsoft is a better choice since its potential annualized returns exceed the Discount Rate by a wider margin (5% vs. 2%).
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How Companies Use the Discount Rate in Corporate Finance and Corporate Development
Internally, large companies use their Discount Rate as a “hurdle rate,” or the minimum return required for a new project, expansion, or acquisition to make sense.
For example, let’s say an auto parts manufacturing company based in the U.S. wants to expand into new geographies.
The company’s overall Discount Rate is 12%, which reflects operations across several countries currently.
It is considering expansion into South America and Africa, and the Discount Rate differs in each region:
- South America: 15%
- Africa: 20%
Africa has a higher Discount Rate because it is riskier than South America, even though most countries on both continents are considered emerging markets. However, Africa also has more growth potential.
The company runs the numbers and determines that the annualized rate of return on a new auto plant in South America would be 16%, but the annualized return on a similar plant in Africa would be 18%.
Even though the annualized return for Africa is higher, it’s below the African Discount Rate, so that plant does not make sense.
The company should pursue the South American plant because the 16% annualized return beats the 15% Discount Rate.
In other words, the potential annualized returns on a specific project mean something only when compared to the expectations for that specific project.
How to Calculate the Discount Rate in Financial Models
In a standard discounted cash flow (DCF) model based on Unlevered Free Cash Flow, the Weighted Average Cost of Capital (WACC) acts as the Discount Rate.
This is because WACC represents all the investors in the company – Equity, Debt, and Preferred – and Unlevered Free Cash Flow represents the cash flow available to all the investors.
If a company uses 60% Equity and 40% Debt to fund its operations, a simple calculation for its Discount Rate might look like this:
We estimate the “cost” of each form of capital the company is using, multiply by the percentages of each one in the company’s capital structure, and add up everything:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock
The Cost of Equity represents the potential annualized return on the company’s common shares, including both dividends and stock-price appreciation.
The Cost of Debt represents the yield to maturity (YTM) on the company’s Debt, which includes both the interest payments and changes in its market value.
(There are many metrics for bond yields, and we cover them in separate articles on this site, so please see those for more.)
We multiply the Cost of Debt by (1 – Tax Rate) because the Interest Expense is tax-deductible to the company (with some limitations, depending on the region).
The Cost of Preferred Stock represents the expected annualized yield on Preferred Stock, which is based on its Preferred Dividends and changes in its market value.
Preferred Stock is like Debt, but it has higher coupon rates and Preferred Dividends are not tax-deductible. So, it is a more expensive form of financing that is junior to traditional Debt and senior to Common Equity.
For example, if traditional Debt has a coupon rate of 6%, Preferred Stock might have a rate closer to 10% because it is riskier.
Calculating the “costs” of these components is straightforward, but there’s some debate about which numbers to use for the capital structure percentages.
We tend to take a middle-of-the-road approach and use averages based on the company’s current capital structure and the median capital structure percentages of its comparable companies.
Here’s an example for Michael Hill, a jewelry retailer in Australia and New Zealand:
You should use the market values of the Equity, Debt, and Preferred Stock in this formula – and especially for Equity.
A company’s Market Cap or Equity Value usually differs from its Common Shareholders’ Equity by a huge percentage, so using the market value there is critical.
For Debt and Preferred Stock, the market value and book value tend to be much closer, so finding the market value is less critical.
This distinction matters a lot more for distressed and stressed companies, where it is also easier to find the market value of Debt.
A Quick Way to Calculate the Discount Rate
We have separate articles explaining how to calculate the Discount Rate and how the WACC formula works, so we’ll refer you to those rather than repeating everything here.
In short, you can follow these steps to calculate the Discount Rate quickly:
1) Look up the company’s Equity Value, Debt, and Preferred Stock – You’ll use the percentage of the capital structure each represents in the WACC formula.
2) Make Quick Estimates for the Cost of Debt and Preferred – For example, take the company’s Interest Expense, divide by its average Debt balance, and multiply by (1 – Tax Rate). Preferred Stock is similar but without the tax adjustment.
It is better to find the fair market value of the company’s Debt and use that to calculate its Yield to Maturity (YTM) or look up its YTM on a source like Bloomberg – but if not, just rely on the financial statements.
3) Get the Information Required for the Cost of Equity – You’ll need the Risk-Free Rate, Equity Risk Premium, and the company’s “Levered Beta,” or the correlation of its stock price to the overall stock market.
For the Risk-Free Rate, you normally use the 10-year government bond yield of the company’s country, so for a U.S. company, you would use the current 10-year U.S. Treasury Yield, which you can easily find online.
You can also look up estimates for the Equity Risk Premium online; it represents the premium the stock market is expected to return over the 10-year government bond yield.
To find the Levered Beta for the company, you can use paid sources like Capital IQ or Bloomberg or, if you don’t have access, free sources like Finviz or Yahoo Finance.
Let’s say you complete this process and get the following results for a company you’re analyzing:
- Equity Value (Market Cap): $1 billion
- Debt: $200 million
- Preferred Stock: $100 million
- Tax Rate: 25.0%
- Cost of Debt: 7.0% (based on an Interest Expense of $14 million / $200 million of Debt)
- Cost of Preferred: 10.0%
- Risk-Free Rate: 5.0%
- Equity Risk Premium: 6.0%
- Levered Beta: 1.2
Based on these results, the % Equity is $1 billion / ($1 billion + $200 million + $100 million) = 77%. The % Debt is 15%, and the % Preferred is 8%.
The Cost of Equity equals the Risk-Free Rate + Equity Risk Premium * Levered Beta, or 5.0% + 6.0% * 1.2 = 12.2%.
We can now apply the WACC formula:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock
WACC = 12.2% * 77% + 7.0% * (1 – 25.0%) * 15% + 10.0% * 8% = ~11%.
This result means that if you invest proportionally in the company’s capital structure, you might expect to earn 11% per year, on average, over the long term.
For the company, it means that any new projects, expansions, or acquisitions they undertake should have potential annualized returns of at least 11% to be justified.
