Question

You are evaluating a new project for the firm you work for, a publicly listed firm. The firm typically finances new projects using the same mix of financing as in its capital structure, but this project is in a different industry than the firm’s core business. Describe the procedure for estimating the appropriate discount rate (cost of capital) to be used in the evaluation of the project

Answer 1

the discount rate is used in discounted cash flow analysis to compute a net present value.   The discount rate is defined below:

Discount Rate – The discount rate is used in discounted cash flow analysis to compute the present value of future cash flows. The discount rate reflects the opportunity costs, inflation, and risks accompanying the passage of time.

There is not a one-size-fits-all approach to determining the appropriate discount rate. That is why our meeting went from a discussion to a lively debate. However, a general rule of thumb for selecting an appropriate discount rate is the following:

Small investors: Discount Rate = the investors’ required rate of return

Institutional investors: Discount Rate = Weighted Average Cost of Capital (WACC)

*WACC is defined as the weighted average of all capital sources used to finance an investment (i.e. debt & equity sources).

Using this approach, investors are able to ensure that their initial investment in the asset achieves their return objectives. Now that we have definitions and basics out of the way, lets dive into how discount rates are determined in practice and in theory.

Special considerations

What is the appropriate discount rate to use for an investment or a business project? While investing in standard assets, like treasury bonds, the risk-free rate of return is often used as the discount rate. On the other hand, if a business is assessing the viability of a potential project, they may use the weighted average cost of capital (WACC) as a discount rate, which is the average cost the company pays for capital from borrowing or selling equity. In either case, the net present value of all cash flows should be positive to proceed with the investment or the project.

If we are talking of price, the discount is taken as a percentage of the full price.
If an item is for sale at original price of 100. Then the merchant offers a 12% discount.
12% of 100 is 12.

The main factor that determines what discount rate should we use in a DCF is the type of cash flows we are discounting.

If we are discounting cash flows that are available to all stakeholders - both debt and equity holders, then we should use a measure like Weighted Average Cost of Capital (WACC). It considers both debt and equity:

What about DCF models that consider only cash flows that are available to equity holders (like the ones we use when valuing a bank)?

Well, in that case the appropriate discount factor is cost of equity (ke).