Question

select the applicable discount rate finding ?

1. all 3 findings relate to discounting rate 2. pv of capital equal future capital value interest 3.the pv of future cash determination 4.discounting is an advance also called interest calculation

Answer 1

1. All 3 findings relate to discounting rate :

(1) Cost of equity

Net Present Value or NPV is the resultant of the present value of cash inflows minus the present value of cash outflows. It is used as a capital budgeting tool to assess the viability of a long term project. A positive NPV means better returns, hence a profitable project, while a negative NPV means cash outflows, which means an investment option best avoided. NPV uses the Time Value of money into consideration. It compares the value of a rupee today to the value of that same rupee in the future, considering inflation and returns. The discount rate used to arrive at this is the cost of equity. The cash flows that are considered are the cash flows to equity holders.

(2) WACC (Weighted average cost of capital)

In the discounted cash flow analysis, the discount rate is the cost of capital from all sources, including equity, bonds and long-term debt. The weightage applied to the cost of equity and cost of equity is the weight of the equity and debt, respectively, in the capital structure. Eg:

E= Equity, D=Debt, V= Market value of the firm (Equity+Debt), Re=Return on Equity, Rd=Cost of debt, Tc=Tax rate

Most of the companies use WACC as the cost of capital because it is the minimum return required by the companies. As a rule companies should invest only in projects that generate returns more than WACC.

(3) Interest rate of the bond

As per the traditional approach of bond valuation, the single cash flows are discounted at the appropriate interest rate. This rate of interest used to discount the bond’s cash flows is called the yield to maturity (YTM.) The YTM (Yield to Maturity) is the annualized return of the bond which is purchased today and held to maturity.

2.PV of capital equal future capital value interest :

In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of zero- or negative interest rates, when the present value will be equal or more than the future value.Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent.Just as rent is paid to a landlord by a tenant without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds (the present value) is less than the total amount of money paid to the lender.

3.The pv of future cash determination:

Net present value (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit.

Example:

N=3 yrs

r=6% annually

PMT = $100 annually

start at the end of the 1st year What is the PV?

Answer = 100/6% * (1 – 1/(1+6%)^3)

4.Discounting is an advance also called interest calculation:

Discount Rate is the interest rate that the Federal Reserve Bank charges to the depository institutions and to commercial banks on its overnight loans. It is set by the Federal Reserve Bank, not determined by the market rate of interest. An interest rate is an amount charged by a lender to a borrower for the use of assets. Interest rates are mostly calculated on an annual basis, which is also known as the annual percentage rate. The assets borrowed can be cash, large assets such as a piece of machinery, vehicles or building.

After examining the above information, we can say that Discount Rate vs Interest Rate are two different concepts. A discount rate is a broader concept of Finance which is having multi-definitions and multi-usage. Whereas Interest rate has a narrow definition and usage, however, multi things are to consider before determining the interest rates. In some cases, you have to pay to borrow money then it is a direct financial cost. In other cases, when you invest money in an investment, and the invested money cannot be utilized in anything else, then there is an opportunity cost. Discount Rates vs Interest rates both are related to the cost of money but in a different way. If you have an interest in Finance and want to work in the Financial Sector in the future, then you should know the difference between Interest rates and Discount rate.