Discount Rate Formula: Calculating Discount Rate [WACC/APV] (2023)

Let’s say you’re the CEO of WellProfit, a growing, Boise-based SaaS company that’s bound for the stars and thinking about getting investors. One of the first things you need to do to make your company attractive to investors is find your discount rate.

Measuring your discount rate as a business, however, can be a complex proposition. For both companies and investors, discount rate is a key metric when positioning for the future. An accurate discount rate is crucial to investing and reporting, as well as assessing the financial viability of new projects within your company.

Setting a discount rate is not always easy, and to do it precisely, you need to have a grasp of the discount rate formula. Finding your discount rate involves an array of factors that have to be taken into account, including your company’s equity, debt, and inventory. Doing it right, however, is key to understanding the future worth of your company compared to its value now and, ultimately, bridging that gap.

Table of Contents:
1. What is a discount rate?
2. NPV and DCF
3. What is discount rate used for?
4. How to calculate discount rate

What is a discount rate?

The definition of a discount rate depends the context, it's either defined as the interest rate used to calculate net present value or the interest rate charged by the Federal Reserve Bank. There are two discount rate formulas you can use to calculate discount rate, WACC (weighted average cost of capital) and APV (adjusted present value).


Interest rate used to calculate Net Present Value (NPV)

The discount rate we are primarily interested in concerns the calculation of your business’ future cash flows based on your company’s net present value, or NPV. Your discount rate expresses the change in the value of money as it is invested in your business over time.

You need to know your NPV when performing discounted cash flow (DCF) analysis, one of the most common valuation methods used by investors to gauge the value of investing in your business. If your company’s future cash flow is likely to be much higher than your present value, and your discount rate can help show this, it can be the difference between being attractive to investors and not.

Interest rate charged by Federal Reserve Bank

The second utility of the term discount rate in business concerns the rate charged by banks and other financial institutions for short-term loans.It’s a very different matterand is not decided by the discount rate formulas we’ll be looking at today.

NPV and DCF

As stated above, net present value (NPV) and discounted cash flow (DCF) are methods of valuation used to assess the quality of an investment opportunity, and both of them use discount rate as a key element.

(Video) FRL3671-Chap 18 APV,FTE and WACC

Net Present Value

NPV is the difference between the present value of a company’s cash inflows and the present value of cash outflows over a given time period. Your discount rate and the time period concerned will affect calculations of your company’s NPV.

NPV is used to measure the costs and benefits, and ultimately the profitability, of a prospective investment over time. It takes inflation and returns into account and features particularly in capital budgeting and investment planning -there’s even a specific Excel function for it. Otherwise, you can calculate it like so:

Discount Rate Formula: Calculating Discount Rate [WACC/APV] (2)

The discount rate element of the NPV formula is used to account for the difference between the value-return on an investment in the future and the money to be invested in the present. Your company’s weighted average cost of capital (WACC, a discount rate formula we’ll show you how to calculate shortly) is often used as the discount rate when calculating NPV, although it is sometimes thought to be more appropriate to use a higher discount rate to adjust for risk or opportunity cost.

Some investors may wish to use a specific figure as a discount rate, depending on their projected return - for instance, if investment funds are to be used to target a specific rate of return, then this rate of return may be used as the discount rate when calculating NPV.

NPV is an indicator of how much value an investment or project adds to your business.

You, as the hypothetical CEO of WellProfit, might find yourself asked to present the net present value of a solution-building project that requires an initial investment of $250,000. It is expected to bring in $40,000 per month of net cash flow over a 12-month period with a target rate of return of 10%, which will act as our discount rate.

NPV = 40,000(Month 1)/1 + 0.1 + 40,000 (Month 2)/1 + 0.1 ... - 250,000

= $230,000

This NPV is not only positive but very high; an investor is likely to go through with the investment, which is good news for WellProfit!

Discounted Cash Flow

DCF is a method of valuation that uses the future cash flows of an investment in order to estimate its value. You can calculate it like so:

Discount Rate Formula: Calculating Discount Rate [WACC/APV] (3)

As the hypothetical CEO of WellProfit, you’d first calculate your discount rate and your NPV (which, remember, is the difference between the present value of cash inflows and the present value of cash outflows over a period of time and is represented above by “CF”).

(Video) May 22 & onwards | CA Inter | FM | New Concept & Illustration | Adjusted Present Value | CS Aditya

Then you can perform a DCF analysis that estimates and discounts the value of all future cash flows by cost of capital to gain a picture of their present values. If this value proves to be higher than the cost of investing, then the investment possibility is viable. Let’s say you have an investor looking to invest in a 20% stake in your company; you're growing at 14.1% per year and produce $561,432 per year in free cash flow, giving your investor a cash return of $112,286 per year. How much is that 20% stake worthnow?

The investor will assess the amount they’ll earn this year ($112,286), in year two ($112,286 x 1.141 = $128,118), and so on. We’ll change our discount rate from our previous NPV calculation. Let’s say now that the target compounded rate of return is 30% per year; we’ll use that 30% as our discount rate. Calculate the amount they earn by iterating through each year, factoring in growth.

You’ll find that, in this case, discounted cash flow goes down (from $86,373 in year one to $75,809 in year two, etc.)because your discount rate is higher than your current growth rate. Therefore, it’s unlikely that, at this growth rate and discount rate, an investor will look at this one as a bright investment prospect. Bad news for WellProfit.

To put it briefly, DCF is supposed to answer the question: "How much money would have to be invested currently, at a given rate of return, to yield the forecast cash flow at a given future date?"You can find out more about how DCF is calculated hereandhere.

What is discount rate used for?

Discount rate is used primarily by companies and investors to position themselves for future success. For companies, that entails understanding the future value of their cash flows and ensuring development is kept within budget. For investors, the discount rate allows them to assess the viability of an investment based on that relationship of value-now to value-later.

Accounting for the time value of money

Money, as the old saying goes, never sleeps. Owing to the rule ofearning capacity, a dollar at a later point in time will not have the same value as a dollar right now. This principle is known as the “time value of money.” We can see how the value of a given sum gradually decreases over time here.

Discount Rate Formula: Calculating Discount Rate [WACC/APV] (4)

As this value is changed by the accumulation of interest and general inflation, as well as by profits and discounts from investments, it’s handy to have the discount rate calculated as a roadmap of where the value of a dollar invested in your business is likely to go.

For instance, if an investor offers your company $1 million for the promise of receiving $7 million in five years’ time, the promise to receive that $7 million 30 years in the future would be worth much less today from the investor’s point of view, even if they were guaranteed payback in both cases (and even though it’s still $7 million dollars!).

Present value (PV), future value (FV), investment timeline measured out in periods (N), interest rate, and payment amount (PMT) all play a part in determining the time value of money being invested. We’ll see a number of those variables included in our discount rate formulas.

Determining potential value / risk factor of future investments

Being able to understand the value of your future cash flows by calculating your discount rate is similarly important when it comes to evaluating both the value potential and risk factor of new developments or investments.

From your company’s side, you can only go ahead with a new project if expected revenue outweighs the costs of pursuing said opportunity. Knowing your discount rate is key to understanding the shape of your cash flow down the line and whether your new development will generate enough revenue to offset the initial expenses.

From the perspective of an investor, including your company’s discount rate in their calculations makes it easier to accurately estimate how much the project's future cash flows are worth now and the size of the present investment needed in order to make an investment profitable.

(Video) Adjusted Present Value (APV)

Calculating NPV (as part of DCF analysis)

As we noted earlier, you can’t gain a full picture of your company's future cash flows without solid DCF analysis; you can't perform DCF analysis without calculating NPV; you can't calculate either without knowing your discount rate.

Without knowing your discount rate, you can’t precisely calculate the difference between the value-return on an investment in the future and the money to be invested in the present. Once you have your NPV calculated this way, you can pair it with your discount rate to get a sense of your DCF.

How to calculate discount rate

There are two primary discount rate formulas - the weighted average cost of capital (WACC) and adjusted present value (APV). The WACC discount formula is:WACC = E/V x Ce + D/V x Cd x (1-T),and the APV discount formula is: APV = NPV + PV of the impact of financing.Let’s dive deeper into these two formulas and how they’re different below.

Weighted Average Cost of Capital (WACC)

WACC can be used to calculate the enterprise value of a firm by considering the cost of goods available for sale against inventory, alongside common stock, preferred stock, bonds, and any other long-term debt on your company’s books.

It is comprised of a blend of the cost of equity and after-tax cost of debt and is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding the products together to determine the WACC value.

The WACC formula for discount rate is as follows:

WACC = E/V x Ce + D/V x Cd x (1-T)

Where:

    • E = Value of equity
    • D = Value of debt
    • Ce = Cost of equity
    • Cd = Cost of debt
    • V = D + E
    • T = Tax rate

This discount rate formula can be modified to account for periodic inventory (the cost of goods available for sale, and the units available for sale at the end of the sales period) or perpetual inventory (the average before the sale of units).

Let’s break it down, and let’s presume WellProfit has taken off and absolutely exploded, and we want to calculate WACC to get a sense of our enterprise value. Let’s say that shareholder equity (E) for the year 2030 will be $4.2 billion and the long-term debt (D) stands at $1.1 billion.

Our overall capital = E + D = 4.2 billion + 1.1 billion = $5.3 billion

The equity linked cost of capital = (E/V) x Re = 4.2/5.3 x 6.6615% = 0.0524

The debt component = (D/V) x Cd x (1-T) = 1.1/5.3 x 6.5% x (1-21%) = - 0.0197

(Video) Weighted Average Cost of Capital (WACC)

WACC = 0.0524 + -0.0197 = 3.2%

Adjusted Present Value (APV)

Our second discount rate formula, the adjusted present value calculation, makes use of NPV. APV analysis tends to be preferred in highly leveraged transactions; unlike a straightforward NPV valuation, it “takes into consideration the benefits of raising debts (e.g., interest tax shield)."

APV can also be useful when revealing the hidden value of seemingly less viable investment opportunities. By considering financing investment with a portion of debt, some prospects that might’ve looked unviable with NPV alone suddenly seem more attractive as investment possibilities.

This second discount rate formula is fairly simple and uses the cost of equity as the discount rate:

APV = NPV + PV of the impact of financing

Where:

    • NPV = Net Present Value
    • PV = Present Value

Discount rate is key to managing the relationship between an investor and a company, as well as the relationship between a company and its future self.

The health of cash flow, not just now but in the future, is fundamental to the health of your business -82% of all startups without reliable cash flows will ultimately fold.Investing in one is a risk, and investors need to know that the value of your cash flows will hold not only now but also later.

In order to manage your own expectations for your company, and in order for investors to vet the quality of your business as an investment opportunity, you need to know how to find that discount rate. Using the right discount rate formula, setting the right rate relative to your equity, debt, inventory, and overall present value is paramount.


By Patrick Campbell

Founder & CEO of ProfitWell, the software for helping subscription companies with their monetization and retention strategies, as well as providing free turnkey subscription financial metrics for over 20,000 companies. Prior to ProfitWell Patrick led Strategic Initiatives for Boston-based Gemvara and was an Economist at Google and the US Intelligence community.

(Video) (13 of 17) Ch.14 - Calculate WACC & then NPV: example

FAQs

What is the formula of discount rate? ›

The formula to calculate the discount rate is: Discount % = (Discount/List Price) × 100.

Do you use WACC for discount rate? ›

WACC is used in financial modeling (it serves as the discount rate for calculating the net present value of a business). It's also the hurdle rate that companies use when analyzing new projects or acquisition targets.

How do you find the discount rate on a DCF model? ›

The discount rate is by how much you discount a cash flow in the future. For example, the value of $1000 one year from now discounted at 10% is $909.09. Discounted at 15% the value is $869.57. Paying $869.57 today for $1000 one year from now gives you a 15% return on your investment.

What is the discount rate in the NPV formula? ›

It's the rate of return that the investors expect or the cost of borrowing money. If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV. If the firm pays 4% interest on its debt, then it may use that figure as the discount rate.

What is discounted rate? ›

The discount rate is the interest rate charged to commercial banks and other financial institutions for short-term loans they take from the Federal Reserve Bank. The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.

How do you use discount rate? ›

The discount rate formula is as follows.
  1. Discount Rate = (Future Value ÷ Present Value) ^ (1 ÷ n) – 1.
  2. Net Present Value (NPV) = Σ Cash Flow ÷ (1 + Discount Rate) ^ n.
  3. WACC = [ke × (E ÷ (D + E))] + [kd × (D ÷ (D + E))]
  4. After-Tax Cost of Debt = Pre-Tax Cost of Debt * (1 – Tax Rate %)

What is the difference between discount rate and WACC? ›

The discount rate is an investor's desired rate of return, generally considered to be the investor's opportunity cost of capital. The Weighted Average Cost of Capital (WACC) represents the average cost of financing a company debt and equity, weighted to its respective use.

How do you calculate WACC example? ›

You can calculate WACC by applying the formula: WACC = [(E/V) x Re] + [(D/V) x Rd x (1 - Tc)], where: E = equity market value. Re = equity cost.

What discount rate should I use? ›

In other words, the discount rate should equal the level of return that similar stabilized investments are currently yielding. If we know that the cash-on-cash return for the next best investment (opportunity cost) is 8%, then we should use a discount rate of 8%.

How do I calculate a discount rate in Excel? ›

The formula for calculating the discount rate in Excel is =RATE (nper, pmt, pv, [fv], [type], [guess]).

What is the discount rate today? ›

Federal discount rate
This WeekMonth Ago
Federal Discount Rate3.253.25

What is the 2022 discount rate? ›

The Federal Reserve Board approved action on Wednesday by the Board of Directors of the Federal Reserve Bank of Kansas City increasing the discount rate, specifically the primary credit rate, at the Bank from 1-3/4 percent to 2-1/2 percent, effective July 28, 2022.

How do you calculate NPV using WACC? ›

Calculate the individual present values

Convert the WACC to a decimal from a percentage and add it to one. Then, divide the cash flow for the period by the result. Continue this for each period of time until complete. You can multiply the WACC plus one calculation by itself for each additional time period.

What is the relationship between NPV and discount rate? ›

Note that NPV and discount rate have an inverse relationship. The higher the rate, the lower the NPV and vice versa. This is because the future cash flows reduce in value if discounted at a higher rate. Therefore, a lower rate is always desirable.

What is a discount factor? ›

What is a “Discount Factor”? The term “discount factor” in financial modeling is most commonly used to compute the present value of future cash flows values. It is a weighting factor (or a decimal number) that is multiplied by the future cash flow to discount it to the present value.

Who sets the discount rate? ›

The discount rate is the interest rate on secured overnight borrowing by depository institutions, usually for reserve adjustment purposes. The rate is set by the Boards of Directors of each Federal Reserve Bank. Discount rate changes also are subject to review by the Board of Governors of the Federal Reserve System.

What is a 7% discount rate? ›

For instance, an investor might have $10,000 to invest and must receive at least a 7 percent return over the next 5 years in order to meet his goal. This 7 percent rate would be considered his discount rate. It's the amount that the investor requires in order to make the investment.

What is discounted rate of return? ›

In corporate finance, a discount rate is the rate of return used to discount future cash flows back to their present value. This rate is often a company's Weighted Average Cost of Capital (WACC), required rate of return, or the hurdle rate that investors expect to earn relative to the risk of the investment.

Why is a discount rate important? ›

The discount rate serves as an important indicator of the condition of credit in an economy. Because raising or lowering the discount rate alters the banks' borrowing costs and hence the rates that they charge on loans, adjustment of the discount rate is considered a tool to combat recession or inflation.

Is discount rate the same as cost of capital? ›

The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. Cost of capital is often calculated by a company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.

Is discount factor the same as discount rate? ›

The discount factor and discount rate are closely related, but while the discount rate looks at the current value of future cash flow, the discount factor applies to NPV. With these figures in hand, you can forecast an investment's expected profits or losses, or its net future value.

Why is WACC used to calculate NPV? ›

The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm's opportunity cost. Thus, it is used as a hurdle rate by companies.

When should WACC not be used? ›

Unfortunately, the WACC is flawed as the discount rate because it carries far too many false assumptions, relies on beta as a form of risk, and can be misleading due to the tax shield on the cost of debt. Individual/retail investors should therefore avoid using the WACC as their discount rate for valuation purposes.

Where do I find WACC? ›

WACC can be found in the Cost of Capital table.

What does WACC measure? ›

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.

Why do we use 10% discount rate? ›

For example, an investor expects a $1,000 investment to produce a 10% return in a year. In that case, the discount rate for valuing this investment or comparing it to others is 10%. The discount rate allows investors and others to consider risk in an investment and set a benchmark for future investments.

How do you find the discount factor on a calculator? ›

How to Calculate Discounting Factors on Calculator - YouTube

Which of the following is true about the discount rate? ›

Answer and Explanation: The answer is c. It is the interest rate at which depository institutions can borrow from the Federal Reserve. The federal discount rate is the interest rate at which Federal Reserve lends funds to financial institutions.

What's the difference between discount rate and interest rate? ›

Put simply, interest rates are the amount that a lender charges on the amount that they loan. In contrast, discount rates are the amount the Federal Reserve Banks charge financial institutions on overnight loans.

What is high discount rate? ›

The discount rate is used to express future monetary value in today's terms. Using a higher discount rate reduces the value of the future stream of net benefits or costs compared with a lower rate. Therefore, a higher discount rate implies that we value benefits less the further they are in the future.

Is discount rate same as inflation? ›

Inflation is how the price of goods generally increases, and can be an appropriate substitute for figuring out the future value of money. However, “discount rate”, is a term which is unique to individuals and business entities.

What is a high discount rate in economics? ›

The use of a high discount rate implies that people put less weight on the future and therefore that less investment is needed now to guard against future costs. Indeed, high discount rates have been described as favouring arguments against regulations to reduce greenhouse gas emissions.

How do you find NPV without discount rate? ›

What is the formula for net present value?
  1. NPV = Cash flow / (1 + i)^t – initial investment.
  2. NPV = Today's value of the expected cash flows − Today's value of invested cash.
  3. ROI = (Total benefits – total costs) / total costs.

Why does NPV change as discount rate increases? ›

Higher discount rates result in lower present values. This is because the higher discount rate indicates that money will grow more rapidly over time due to the highest rate of earning.

What is the NPV method? ›

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.

What is discounting method? ›

Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow. Discounting is the primary factor used in pricing a stream of tomorrow's cash flows.

What is the discount rate today? ›

Federal discount rate
This WeekMonth Ago
Federal Discount Rate3.253.25

What is the 2022 discount rate? ›

The Federal Reserve Board approved action on Wednesday by the Board of Directors of the Federal Reserve Bank of Kansas City increasing the discount rate, specifically the primary credit rate, at the Bank from 1-3/4 percent to 2-1/2 percent, effective July 28, 2022.

Is discount rate same as interest rate? ›

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility—the discount window.

Who sets the discount rate? ›

The discount rate is the interest rate on secured overnight borrowing by depository institutions, usually for reserve adjustment purposes. The rate is set by the Boards of Directors of each Federal Reserve Bank. Discount rate changes also are subject to review by the Board of Governors of the Federal Reserve System.

Which of the following is true about the discount rate? ›

Answer and Explanation: The answer is c. It is the interest rate at which depository institutions can borrow from the Federal Reserve. The federal discount rate is the interest rate at which Federal Reserve lends funds to financial institutions.

What is high discount rate? ›

The discount rate is used to express future monetary value in today's terms. Using a higher discount rate reduces the value of the future stream of net benefits or costs compared with a lower rate. Therefore, a higher discount rate implies that we value benefits less the further they are in the future.

What is the difference between discount rate and federal funds rate? ›

The fed funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans. The discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions.

Is discount rate same as inflation? ›

Inflation is how the price of goods generally increases, and can be an appropriate substitute for figuring out the future value of money. However, “discount rate”, is a term which is unique to individuals and business entities.

Why is it called discounted rate? ›

The term “discount rate” is used when looking at an amount of money to be received in the future and calculating its present value. The word “discount” means “to deduct an amount.” A discount rate is deducted from a future value of money to provide its present value.

How do I calculate a discount rate in Excel? ›

The formula for calculating the discount rate in Excel is =RATE (nper, pmt, pv, [fv], [type], [guess]).

Why is the discount rate important? ›

The discount rate serves as an important indicator of the condition of credit in an economy. Because raising or lowering the discount rate alters the banks' borrowing costs and hence the rates that they charge on loans, adjustment of the discount rate is considered a tool to combat recession or inflation.

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