{"id":29924,"date":"2024-08-23T22:27:11","date_gmt":"2024-08-24T03:27:11","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=29924"},"modified":"2024-12-16T23:28:14","modified_gmt":"2024-12-17T04:28:14","slug":"discount-rate","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/finance\/discount-rate\/","title":{"rendered":"The Discount Rate Defined: Full Explanation and Excel Examples"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">The Discount Rate Defined: Full Explanation and Excel Examples<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/discount-rate\/#How_Companies_Use_the_Discount_Rate_in_Corporate_Finance_and_Corporate_Development\">How Companies Use the Discount Rate in Corporate Finance and Corporate Development<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/discount-rate\/#How_to_Calculate_the_Discount_Rate_in_Financial_Models\">How to Calculate the Discount Rate in Financial Models<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/discount-rate\/#A_Quick_Way_to_Calculate_the_Discount_Rate\">A Quick Way to Calculate the Discount Rate<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>Discount Rate Definition:<\/strong> 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 <em>minimum return required<\/em>; to investors, it represents the opportunity cost.<\/p><\/blockquote>\n<p>The Discount Rate can be specific to <em>one group of investors<\/em> (e.g., just the equity investors or common shareholders), or it can be for all the investors in a company or project.<\/p>\n<p>We use the Discount Rate to calculate the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/present-value\/\" target=\"_blank\" rel=\"noopener\">Present Value<\/a> of the future cash flows generated by a company or asset \u2013 in other words, what those future cash flows are worth to us <em>today<\/em>:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29926 size-full\" title=\"Discount Rate Example\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222606\/01-Discount-Rate-Example.jpg\" alt=\"Discount Rate Example\" width=\"1342\" height=\"550\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222606\/01-Discount-Rate-Example.jpg 1342w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222606\/01-Discount-Rate-Example-300x123.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222606\/01-Discount-Rate-Example-1024x420.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222606\/01-Discount-Rate-Example-768x315.jpg 768w\" sizes=\"(max-width: 1342px) 100vw, 1342px\" \/><\/p>\n<p>The <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/time-value-of-money\/\" target=\"_blank\" rel=\"noopener\">time value of money<\/a> tells us that money tomorrow is worth less than money today because we could invest the money today and <em>earn more with it<\/em> by tomorrow.<\/p>\n<p>The <strong>Discount Rate<\/strong> lets us <em>quantify<\/em> this difference and compare different investment opportunities.<\/p>\n<p>A higher Discount Rate indicates higher risk and greater potential upside, while a lower Discount Rate means lower risk and lower potential upside.<\/p>\n<p>The Discount Rate has dozens of uses in finance, but for a simple example, consider whether you would invest in <strong>Google<\/strong> or <strong>Microsoft<\/strong>.<\/p>\n<p>They\u2019re both massive tech companies, and from a quick analysis, you believe their appropriate <strong>Discount Rate<\/strong> is approximately 10%.<\/p>\n<p>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.<\/p>\n<p>This Discount Rate sets your <strong>expectations<\/strong> as an investor, but it doesn\u2019t represent what you could earn by investing in <em>just one specific company <\/em>in this set.<\/p>\n<p>To determine that, you need to project each company\u2019s cash flows and possible valuation in the future.<\/p>\n<p>From that analysis, you might determine that you could earn a 15% annualized return with Microsoft but only 12% with Google.<\/p>\n<p>Therefore, both companies are viable investment candidates since both their <em>expected returns<\/em> exceed the Discount Rate.<\/p>\n<p>However, Microsoft is a better choice since its potential annualized returns exceed the Discount Rate by a wider margin (5% vs. 2%).<\/p>\n<h3><strong>Files &amp; Resources:<\/strong><\/h3>\n<ul>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Finance\/PV-NPV-IRR-WACC.xlsx\" target=\"_blank\" rel=\"noopener\">PV, NPV, IRR, and WACC \u2013 Simple Excel Examples (XL)<\/a><\/li>\n<\/ul>\n<h2><span class=\"ez-toc-section\" id=\"How_Companies_Use_the_Discount_Rate_in_Corporate_Finance_and_Corporate_Development\"><\/span><strong>How Companies Use the Discount Rate in Corporate Finance and Corporate Development<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Internally, large companies use their Discount Rate as a <strong>\u201churdle rate,\u201d<\/strong> or the minimum return required for a new project, expansion, or acquisition to make sense.<\/p>\n<p>For example, let\u2019s say an auto parts manufacturing company based in the U.S. wants to expand into new geographies.<\/p>\n<p>The company\u2019s <em>overall<\/em> Discount Rate is 12%, which reflects operations across several countries currently.<\/p>\n<p>It is considering expansion into <strong>South America<\/strong> and <strong>Africa<\/strong>, and the Discount Rate differs in each region:<\/p>\n<ul>\n<li><strong>South America:<\/strong> 15%<\/li>\n<li><strong>Africa:<\/strong> 20%<\/li>\n<\/ul>\n<p>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.<\/p>\n<p>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%.<\/p>\n<p><strong>Even though the annualized return for Africa is higher, it\u2019s <em>below<\/em> the African Discount Rate, so that plant does not make sense.<\/strong><\/p>\n<p><strong>The company should pursue the South American plant because the 16% annualized return beats the 15% Discount Rate.<\/strong><\/p>\n<p>In other words, the potential annualized returns on a specific project mean something only when compared to the <em>expectations<\/em> for that specific project.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_the_Discount_Rate_in_Financial_Models\"><\/span><strong>How to Calculate the Discount Rate in Financial Models<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>In a standard\u00a0<span><a href=\"https:\/\/mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">discounted cash flow (DCF) model<\/a><\/span>\u00a0based on\u00a0<span><a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/unlevered-free-cash-flow\/\" target=\"_blank\" rel=\"noopener\">Unlevered Free Cash Flow<\/a><\/span>, the <span><a href=\"https:\/\/mergersandinquisitions.com\/wacc-formula\/\" target=\"_blank\" rel=\"noopener\">Weighted Average Cost of Capital (WACC)<\/a><\/span> acts as the Discount Rate.<\/p>\n<p>This is because WACC represents <em>all the investors<\/em> in the company \u2013 Equity, Debt, and Preferred \u2013 and Unlevered Free Cash Flow represents the cash flow <em>available<\/em> to all the investors.<\/p>\n<p>If a company uses 60% Equity and 40% Debt to fund its operations, a simple calculation for its Discount Rate might look like this:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29927 size-full\" title=\"Simple Discount Rate Calculation\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate.jpg\" alt=\"Simple Discount Rate Calculation\" width=\"1597\" height=\"334\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate.jpg 1597w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate-300x63.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate-1024x214.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate-768x161.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222628\/02-Simple-Discount-Rate-1536x321.jpg 1536w\" sizes=\"(max-width: 1597px) 100vw, 1597px\" \/><\/p>\n<p>We estimate the \u201ccost\u201d of each form of capital the company is using, multiply by the percentages of each one in the company\u2019s capital structure, and add up everything:<\/p>\n<p><strong>WACC = Cost of Equity * % Equity + Cost of Debt * (1 \u2013 Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock<\/strong><\/p>\n<p>The Cost of Equity represents the potential annualized return on the company\u2019s common shares, including both dividends and stock-price appreciation.<\/p>\n<p>The Cost of Debt represents the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/yield-to-maturity\/\" target=\"_blank\" rel=\"noopener\">yield to maturity (YTM)<\/a> on the company\u2019s Debt, which includes both the interest payments and changes in its market value.<\/p>\n<p>(There are many metrics for <a href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/bond-yield\/\" target=\"_blank\" rel=\"noopener\">bond yields<\/a>, and we cover them in <a href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/\" target=\"_blank\" rel=\"noopener\">separate articles on this site<\/a>, so please see those for more.)<\/p>\n<p>We multiply the Cost of Debt by (1 \u2013 Tax Rate) because the Interest Expense is tax-deductible to the company (with some limitations, depending on the region).<\/p>\n<p>The Cost of Preferred Stock represents the expected annualized yield on Preferred Stock, which is based on its <strong>Preferred Dividends<\/strong> and changes in its market value.<\/p>\n<p>Preferred Stock is like Debt, but it has higher coupon rates and Preferred Dividends are <strong>not<\/strong> tax-deductible. So, it is a more expensive form of financing that is <em>junior<\/em> to traditional Debt and <em>senior<\/em> to Common Equity.<\/p>\n<p>For example, if traditional Debt has a coupon rate of 6%, Preferred Stock might have a rate closer to 10% because it is riskier.<\/p>\n<p>Calculating the \u201ccosts\u201d of these components is straightforward, but there\u2019s some debate about which numbers to use for the capital structure percentages.<\/p>\n<p>We tend to take a middle-of-the-road approach and use averages based on the company\u2019s <em>current<\/em> capital structure and the median capital structure percentages of its <a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/comparable-company-analysis-cca\/\" target=\"_blank\" rel=\"noopener\">comparable companies<\/a>.<\/p>\n<p>Here\u2019s an example for Michael Hill, a jewelry retailer in Australia and New Zealand:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29928 size-full\" title=\"Michael Hill - Discount Rate Calculation\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate.jpg\" alt=\"Michael Hill - Discount Rate Calculation\" width=\"1782\" height=\"518\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate.jpg 1782w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate-300x87.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate-1024x298.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate-768x223.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/23222653\/03-Michael-Hill-Discount-Rate-1536x446.jpg 1536w\" sizes=\"(max-width: 1782px) 100vw, 1782px\" \/><\/p>\n<p><strong>You should use the <em>market values<\/em> of the Equity, Debt, and Preferred Stock in this formula \u2013 and especially for Equity.<\/strong><\/p>\n<p>A company\u2019s Market Cap or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/equity-value-enterprise-value\/\" target=\"_blank\" rel=\"noopener\">Equity Value<\/a> usually differs from its <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/statements-of-owners-equity\/\" target=\"_blank\" rel=\"noopener\">Common Shareholders\u2019 Equity<\/a> by a huge percentage, so using the market value there is critical.<\/p>\n<p>For Debt and Preferred Stock, the market value and book value tend to be much closer, so finding the market value is less critical.<\/p>\n<p>This distinction matters a lot more for distressed and stressed companies, where it is also easier to find the market value of Debt.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"A_Quick_Way_to_Calculate_the_Discount_Rate\"><\/span><strong>A Quick Way to Calculate the Discount Rate<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>We have separate articles explaining <a href=\"https:\/\/breakingintowallstreet.com\/how-to-calculate-discount-rate\/\" target=\"_blank\" rel=\"noopener\">how to calculate the Discount Rate<\/a> and how the <a href=\"https:\/\/mergersandinquisitions.com\/wacc-formula\/\" target=\"_blank\" rel=\"noopener\">WACC formula<\/a> works, so we\u2019ll refer you to those rather than repeating everything here.<\/p>\n<p>In short, you can follow these steps to calculate the Discount Rate quickly:<\/p>\n<p><strong>1) Look up the company\u2019s Equity Value, Debt, and Preferred Stock<\/strong> \u2013 You\u2019ll use the percentage of the capital structure each represents in the WACC formula.<\/p>\n<p><strong>\u00a02) <\/strong><strong>Make Quick Estimates for the Cost of Debt and Preferred<\/strong> \u2013 For example, take the company\u2019s Interest Expense, divide by its average Debt balance, and multiply by (1 \u2013 Tax Rate). Preferred Stock is similar but without the tax adjustment.<\/p>\n<p>It is better to find the fair market value of the company\u2019s Debt and use that to calculate its Yield to Maturity (YTM) or look up its YTM on a source like Bloomberg \u2013 but if not, just rely on the financial statements.<\/p>\n<p><strong>\u00a03) <\/strong><strong>Get the Information Required for the Cost of Equity<\/strong> \u2013 You\u2019ll need the Risk-Free Rate, Equity Risk Premium, and the company\u2019s \u201cLevered Beta,\u201d or the correlation of its stock price to the overall stock market.<\/p>\n<p>For the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/risk-free-rate\/\" target=\"_blank\" rel=\"noopener\">Risk-Free Rate<\/a>, you normally use the 10-year government bond yield of the company\u2019s country, so for a U.S. company, you would use the current 10-year U.S. Treasury Yield, which you can easily find online.<\/p>\n<p>You can also look up <a href=\"https:\/\/www.statista.com\/statistics\/664840\/average-market-risk-premium-usa\/\" target=\"_blank\" rel=\"noopener\">estimates for the Equity Risk Premium online<\/a>; it represents the premium the stock market is expected to return <em>over<\/em> the 10-year government bond yield.<\/p>\n<p>To find the Levered Beta for the company, you can use paid sources like Capital IQ or Bloomberg or, if you don\u2019t have access, free sources like Finviz or Yahoo Finance.<\/p>\n<p>Let\u2019s say you complete this process and get the following results for a company you\u2019re analyzing:<\/p>\n<ul>\n<li><strong>Equity Value (Market Cap):<\/strong> $1 billion<\/li>\n<li><strong>Debt:<\/strong> $200 million<\/li>\n<li><strong>Preferred Stock:<\/strong> $100 million<\/li>\n<li><strong>Tax Rate: <\/strong>25.0%<\/li>\n<li><strong>Cost of Debt:<\/strong> 7.0% (based on an Interest Expense of $14 million \/ $200 million of Debt)<\/li>\n<li><strong>Cost of Preferred:<\/strong> 10.0%<\/li>\n<li><strong>Risk-Free Rate:<\/strong> 5.0%<\/li>\n<li><strong>Equity Risk Premium:<\/strong> 6.0%<\/li>\n<li><strong>Levered Beta: <\/strong>1.2<\/li>\n<\/ul>\n<p>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%.<\/p>\n<p>The Cost of Equity equals the Risk-Free Rate + Equity Risk Premium * Levered Beta, or 5.0% + 6.0% * 1.2 = 12.2%.<\/p>\n<p>We can now apply the WACC formula:<\/p>\n<p>WACC = Cost of Equity * % Equity + Cost of Debt * (1 \u2013 Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock<\/p>\n<p>WACC = 12.2% * 77% + 7.0% * (1 \u2013 25.0%) * 15% + 10.0% * 8% = ~11%.<\/p>\n<p>This result means that if you invest <em>proportionally<\/em> in the company\u2019s capital structure, you might expect to earn 11% per year, on average, over the long term.<\/p>\n<p>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.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>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.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-29924","biws_kb","type-biws_kb","status-publish","hentry","kb_category-finance"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/29924","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=29924"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}