What is Discount
Rate ?
The next
step in the Discounted Cash Flow model is the determination of an appropriate
rate to discount future cash flows. The discount
rate is the aggregate of risk-free rate and risk premium to account for
the riskiness of the business. Key inputs
or adjustments for calculating the discount rate are discussed below:
- Theoretically, the risk-free rate is the rate of return on an asset with no default risk. In practice, long-term interest rates on government securities are used as a benchmark.
- It is quite natural to assume that the riskier investments should have a higher return. This necessitates the incorporation of an appropriate risk premium in the discount rate. There exist a number of models for determination of risk premiums, such as the capital asset pricing model, arbitrage pricing model, multi-factor model, etc. The risk premium is also adjusted to incorporate risks associated with the stage and size of the business and other company or project-specific risks.
- The rate estimated by using the above will provide the discount rate, assuming only equity financing or the cost of equity. For a leveraged company, the discount rate should be adjusted for leverage. Practically speaking, the discount rate for a leveraged company is the weighted average cost of capital with appropriate weights to cost of equity and post-tax cost of debt, considering existing or targeted debt-equity ratio, industry standards, and other parameters.
- In the case of a company carrying on two or more different businesses, their cash flow projections should be estimated separately, and apply the discount rates appropriate to the individual businesses.
Terminal
Value
Since a
business is valued as a going concern, its value should account for the cash
flows over the entire life of a company, which can be assumed to be infinite.
Because the cash flows are estimated only for the forecast period, a terminal
value is estimated to reflect the value of the cash flows arising after the
forecast period. Terminal value can be computed in a number of ways; some
prominent ones are discussed below:
- Perpetual growth model assumes that a business has an infinite life and a stable growth rate of cash flows. Terminal value is derived mathematically by dividing the perpetuity cash flows (cash flows which are expected to grow at a stable pace) with the discount rate as reduced by the stable growth rate. Estimation of the stable growth rate is of great significance because even a minor change in stable growth rate can change the terminal value and the business value too. Various factors like the size of a company, existing growth rate, competitive landscape, profit reinvestment ratio, etc. have to be kept in mind while estimating the stable growth rate.
- Multiple approaches involve the determination of an appropriate multiple to be applied on perpetuity earnings or revenues. Multiple is estimated by an analysis of the comparable companies. Though this approach is simpler and brings in the advantages of the market approach, it does not qualify as a preferred approach because it mixes the discounted cash flow approach which provides intrinsic or company-specific valuation with the market approach.
- In valuations that assume a finite life of a business, terminal value is estimated to be the liquidation value, which is based on the book value of the assets adjusted for inflation. But this does not reflect the earning power of the assets. Alternatively, discounting expected cash flows from the sale of such assets at an appropriate discount rate would provide a better estimation of liquidation value.
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