You need to know the rules in order to break them successfully

Discount rate for Discounted Cash Flow

Discounted Cash Flow (DCF) is an entry level financial skill that is described in any textbook, but what discount rate should you use?

Finding Your Company’s Cost of Capital

The textbooks are not much help when deciding what discount rate to use to express your future cash flows in terms of their ‘present value’.  ‘Use the company’s cost of capital’ is the standard advice but how do you know what that is?  It isn’t something that is published in the accounts.

Borrowing

An easy way around the problem is to assume that any new project is financed from borrowing rather from the company’s own cash.  The cost of capital is therefore whatever rate the company can raise loan finance.  This figure will either be ‘known’ because you recently raised debt finance or your finance director will be able to estimate it with reasonable accuracy. You can benchmark your rate with reference to the rates large quoted companies are able to raise finance.  Banks structure loan finance in lots of different ways but a simple estimate would be base rate plus a premium based on your company’s size and risk profile.  Let’s say base + 2% for a mid-market, moderate-good risk enterprise.

I’ve only once used this as a basis of the discount rate.  It was a DCF calculation of a sale and leaseback transaction.  As such transactions are, in effect, borrowing in another guise, we felt pretty comfortable using this method.  We used 6%.  At the time, 2004, base rates were around 4% and it was a company with a very good credit rating.

Cost of Equity

It is more theoretically correct to use the cost of equity capital, or the return expected by shareholders on their investment in your company.  Some big quoted companies make a stab at estimating their cost of equity.  Smaller companies may be able to refer to specific guidance from their owner(s).  For everyone else, I’d recommend taking an average for UK businesses as a whole.

What is the cost of equity the whole of the UK business sector?  My guess is 8.8% (see table below for calculation).

 

This table reverse-engineers a benchmark cost of capital from first principles based on companies’ average profitability and seeks to validate the result with stock market P/E ratios and expected investment returns.  These calculations correspond well with historical data so I’m reasonably satisfied with 8.8%%.  An academic study in the US estimated 8.8% as the long-run cost of equity capital there (An Analysis of S&P500 Index 1870-1999 Wilson and Jones).  Also the long-run average for the Cyclically-Adjusted P/E (CAPE) ratio, calculated by nobel prize-winning Robert Shiller, is 16.4.

Risk

The next factor to take into account is the risk profile of your project.  If your investment project goes beyond ‘business as usual’ for your company you need to adjust the cost of equity to reflect the greater chances of losing money.  The implication of using the average cost of capital for the whole stock-market is that your project carries no more risk than routine commercial activity.  This is quite low in the context of most business investments, where the risk would more typically be ‘medium’.

Examples of low-risk projects would be productivity-improving projects such as purchasing plant and equipment or rolling out an established product in a new territory.  Examples of a medium risk project would be acquiring a company or launching a new product with established technology.  Examples of a high-risk project would be a highly leveraged buy-out or new product launch with new and untested technology.

If your project is riskier than your company’s routine activity, you should adjust the cost of capital upwards.  I advise the following rates are used:

 

I’ve prepared a separate tutorial on investment risk that explains the arithmetic behind these recommendations.

These rates are appropriate for the sort of low-inflation, low political risk countries of the developed world.  Further uplifts will be necessary for riskier business environments.  One of my best jobs was in a Unilever subsidiary that, after the collapse of communism, spent the early nineties selling surplus Unilever production into newly opened countries where Unilever didn’t have a local presence.  Our ‘house’ discount rate, which admittedly incorporated higher inflation / political risk expectations than would be appropriate in these markets today, was 20%.

Weighted Average Cost of Capital

If you really want to be strictly correct, you should adjust the cost of equity capital with the cost of borrowing, weighted to reflect your company’s average gearing ratio.  So if the average UK company is 30% geared and can borrow at 6.5% then, assuming 8.8% is the cost of equity, the weighted average cost of capital would be 8.1%.

 

In most cases weighting the cost of capital is an unnecessary level of complexity and I wouldn’t recommend doing it unless your project specifically involves debt finance.

Capital Asset Pricing Model (CAPM)

For quoted companies another way to calculate your cost of capital is to use the CAPM.  I wouldn’t recommend it however.  Firstly, it’s more appropriate to valuing a bond than a company and, secondly, the assumption that stock price volatility – Beta – is a proxy for risk is a feasible idea but it is not supported by the data.

Public Sector Organisations

If you are in a public sector organisation, HM Treasury has a ‘green book’ of house rules for all sorts of processes and procedures.  Among these has been a long-standing instruction to use 3% as a discount rate.  The concept of a cost of capital doesn’t really translate in a not for profit environment.  Public sector investments are for the public good which by definition wouldn’t be viable for a private sector company, hence a much reduced discount rate makes sense in this case.  Using 3% is doing no more than take account of inflation.

Words of Warning

Don’t spend too much time fretting about what discount rate to use.  Most people, myself included, find the Net Present Values that result from discounted cash flows difficult to interpret.  It’s not the amount of money you’ll make on the project.  It’s the amount of money you’ll make on the project adjusted for the return you could have made investing in alternative projects.  It doesn’t really convey much useful information.  Of much more interest is calculating the rate at which the Net Present Value is zero (the goal-seek function on Excel is good for this purpose).  This calculates the return on the project as a whole, or the Internal Rate of Return to give it its proper title.  This information is useful because, unlike Net Present Values, which often fail to resonate with decision-makers, most people find it easy to compare the returns on different projects.  In these circumstances you can use the discount rate as a ‘hurdle’ over which your project has to leap for it to be acceptable.

Summary

It’s quite easy to calculate a specific cost of capital for your company if you know its profitability and gearing but if you are looking for a benchmark to use for a low risk project I recommend using 8.8%.

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