Question

One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset’s future cash flows. Finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination.

Answer 1

Discounting is to bring to the present , the values of the future cash flows , occuring at different points in the time-line , subsequent to buying an asset or any type of investment or proceeding on a capital project.

All the cash outflows & inflows are brought to time t=0, and on the basis of that netted present value , the asset is bought or the project is undertaken or both rejected.

For bringing the above cash flows to their present values, we need a discount rate ,ie. An interest rate or the required rate of return , at which the cash flows are dicounted to the present time , t=0.

This rate to be used , needs to be as near-accurate as possible , so that the investor gets a true picture , in deciding for or against the investment.

Normally , an investor uses the cost of the funds borrowed , to finance this investment, ie. The interest rate he is going to give the lender, be him, an individual or a bank or any other financial lending institution.

So,

the one variable to be considered in determining the correct discount rate to use is the borrowing rate,ie. The cost of finance rate.

It may also be the opportunity cost of interest lost on one's savings account , if funds are taken from that savings account & invested to buy stocks or bonds .

Or, it may also be the weighted average cost of all the pooled funds-ie. A combination of sources of finance, that are used for funding the investment.

That said,

the role of a correctly-estimated financing cost in determining the discount rate cannot be under-estimated------

as the appraisal about the project's cash flows, by the investor , depends entirely on the accuracy of this rate.

The investor should be doubly sure about his costs, as if he leaves out something & chooses a project/invetsment ,on the basis of the incorrectly calculated lesser discount rate, he may be losing in actual terms.

Else, if he chooses a higher discount rate , by a mistake/errorin calculation, the present values of cash flows may be very low & he may wrongly, reject the project.

So, the investor needs to be very careful in aggregating all his sources of funds,their correct costs . Only then he can arrive at an appropriate and accurate discount rate , to use to find the PVs of the future cash flows, arising from holding the investment.