Discount rate – How 2 best account it

Discount rate – As part of IFRS 13 Fair value measurement the measurement of fair value using the Discounted cash flow model has increased. One of the most influential inputs to a discounted cash flow model is the discount rate/discounting rate. A discount rate is used in different formats in different discounted models.

How is this substantiated so your model is being taken seriously?

The calculation of present value based on discounting future cash flows answers “how much money would have to be invested currently, at a given rate of return, to yield the forecast cash flow, at its future date?” In other words, discounting returns the present value of future cash flows, where the rate used is the cost of capital that appropriately reflects the risk, and timing, of the cash flows.

The required return

This “required return” thus incorporates:

• Time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay
• Risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.

First an illustration, because a picture tells more than a thousand words……

This will illustrate a way to build the equity discount rate used in WACC, DCF and/or Excess Earnings calculations. It will be build up as a specific discount rate for a specific company and always needs to be validated by comparison against recent transactions or so to provide a profound basis for calculating a value.

The discount rate is estimated as follows:

Discount Rate Sensitivity

When it comes to discounted cash flow analysis, your choice of discount rate can dramatically change your valuation. Consider the following chart showing the sensitivity of net present value to changes in the discount rate:

As shown in the analysis above, the net present value for the given cash flows at a discount rate of 10% is equal to CU 0. This means that with an initial investment of exactly $1,000,000, this series of cash flows will yield exactly 10% (the internal rate of return, IRR and the coupon rate of the debt (1,000,000 x 10% is 100,000). As the required discount rates moves higher than 10%, the investment becomes less valuable.

This happens because the higher the discounting rate, the lower the initial investment needs to be in order to achieve the target yield. As you can see in the chart above, the selection of the discount rate can have a big impact on the discounted cash flow valuation.

Issues with discount rates

While the calculation of discounting rates and their use in financial modeling may seem scientific, it is in fact not. There are so many assumptions that are only a “best guess” about what will happen in the future.

Furthermore, only one discounting rate is used at a point in time to value all future cash flows, when in fact, interest rates and risk profiles are constantly changing in a dramatic way.

That is why IFRS 13 Fair value measurement requires a probability weighted calculation of present values in order to improve the quality of a present value valuation.