The Discount Rate in DCF Analysis
As you already know, the discounted cash flow analysis or also known as the DCF Valuation makes use of a key metric such as the discount rate. As time passes by, the value of money tends to change which is mostly decreasing, thus, its purchasing power of income at a period in the future should be worth less compared today’s value. Hence, it is very important to take into account the time value of money when conducting a valuation which pretty much depends mostly on the projection of cash flows in the future.
Basically, the discount rate is the interest rate used in DCF analysis to determine the present value of the future cash flows. It also stands as the interest rate charged to banks and other financial institutions.
For example, we will use a DCF Valuation calculation table to determine the present value of the future cash flows by applying the discount rate.
Using the DCF formula:
The discount rate used here is the WACC which stands for as the average cost the business paid for capital from either borrowing or selling equity.
Calculating the Discount Rate - Using Weighted Average Cost of Capital Calculation
To calculate the discount rate, one must first determine what is the appropriate discount rate to use. Many businesses tend to use their Weighted Average Cost of Capital or WACC if its risk report is similar to that of the business, otherwise, the other option would be to use the Capital Asset Pricing Model (CAPM) as the discount rate instead.
To calculate the discount rate using the WACC, one will need to use the following formula:
Ke = Cost of Equity
Kd = Cost of Debt (average interest rate on business’ debt or use Book Value)
T = Corporate Tax Rate (marginal tax rate)
Ve = Value of Equity (business market cap – cash + debt)
Vd = Value of Debt (proxy is Book Value)
To calculate the discount rate using the CAPM, use the following formula:
Rf = Risk-free rate of return
B (Beta) = Sensitivity of the expected stock return to the market return or covariance of the historical return of a particular stock and the market divided by the variance of the market; B = Cov (Rs,Rm)/Var(Rm)
Rm = Market rate of return
Discount Rate Example Models
If you are looking for DCF Models and learn how to build one yourself, you can see it here: Discounted Cash Flow Models. If you want to learn more how to apply discount rate and how it works, we compiled a list of discount rate example models found above which are specifically designed for different industries and other use cases. These discount rate example models are using the weighted average cost of capital calculation mostly as the basis since it is the most use case when determining the discount rate.
These discount rate example models are ready-made by experienced financial modelers with a wide range of experience in financial modeling and industry know-how. So, the model itself will only need you to input the values according to your figures and customize the ranges or metrics according to your requirements. If you still need help with creating a custom model with discount rate applied, then we can also help you with that. Just feel free to provide us your specifications and we’ll draft you the model as well as give you a proper quotation.