What is the discount rate?

Investing is a must if you want to increase your wealth. It doesn’t matter whether it is an enterprise or personal finances. One of the basic concepts in investing is the discount rate. Let's look at what it is and what calculation methods exist.

Definition

Before deciding to invest in a particular project, investors want to get a preliminary assessment of its effectiveness in order to choose the most profitable option. To do this, use discount, or discounting - a way to determine the value of money at a particular point in time.

The point is that the amount that we have today is always the same in the future. Roughly speaking, ten thousand rubles today is more than a month, and even more so a year later.

This happens for three reasons:

• Inflation constantly reduces the purchasing power of money (today it is possible to purchase goods worth ten thousand rubles more than a month later).
• The amount available can generate income (for example, if you put it in the bank at interest).
• In the future, there is always a risk of not getting money at all.

The discount rate is the amount of profit that an investor could have from an alternative investment. With its help, several investment projects are compared and the most interesting one is selected.

How to calculate the discount?

Calculation of the cost of investment projects is one of the most difficult financial tasks. For a number of enterprises this is a necessity - for example, for those that prepare reports in accordance with IFRS, because there you need to indicate the value of the business and investments, taking into account the influence of the time factor.

There is a wide variety of calculation methods. However, the essence of them all comes down to the following formula:

The value of money in the future = The value of money in the present / (1+ discount rate) x term

The most difficult calculation is to determine the bid. Let's look at the simplest example - placing money in a bank at interest. Three banks offer different rates: 7%, 9% and 12%. Here, even without a formula, it can be seen that the most profitable investment option is the latter.

But how to understand, it is more profitable to invest ten thousand rubles in a project that will turn them into fifteen thousand in 18 months, or put in a bank for the same period at interest? How to determine whether it is effective to attract borrowed funds to participate in investing or is it better to limit yourself to using your own?

The calculation of the discount rate should always take into account the value of inflation. In other words, even if the money is simply in the current account and not used in any way, a discount rate equal to the current inflation rate will also be applied to them, which will decrease the amount over time.

Setting the norm

This is a fundamental point in the calculations. The discount rate (discount rate) is the size of the return that could be obtained if the investor used an alternative method of investment. An example is the interest rate on a deposit at a bank. In this case, we can say that the discount rate is equal to it.

If the profitability of the project is lower than what is accepted as the norm, then the investor refuses to participate, if higher, then he makes a positive decision. What to use as a basic parameter, each enterprise decides for itself independently.

The identity "bank rate = discount rate" is not always used. The starting point may be:

• profitability of any securities;
• subjective indicators based on the expert opinion of the financial specialists of the enterprise;
• investment risk level and inflation growth rate;
• cost of capital reduced to the average.

The bottom line is that the discount rate is the return on capital invested in affordable investment instruments on the market with a minimum level of risk, adjusted to the current inflation rate.

Various factors can influence the rate: bank interest, the availability of various investment instruments, changes in tax rates and inflation, and much more.

Internal rate of discount

This is such an indicator at which the financial effect of investments is zero. The manuals are found in the form of the abbreviation IRR.

In other words, this indicator demonstrates that the owner will not suffer losses from these investments. Peculiar break even. The internal discount rate (formula) looks like this:

0 = ⁿthe amount_{t = 1} x CFt / (1 + IRR)^t - IC, where:

• CFt - cash flows of the enterprise for a certain period of time;
• IC - costs that the investor will incur if invested in the project;
• t is the time period.

Therefore, if the IRR is higher than the cost, then such a project should be considered as attractive. If below, then you need to refuse to participate in it. Thus, the internal discount rate is the starting point in the analysis of the project.

Methods for calculating the discount rate

There are at least ten calculation methods. Among them, there are those that use expert judgment, profitability, the dividend model, and others as the basis. The most common and least labor-intensive are two calculation methods:

• enlarged;
• cumulative.

The first is also called the weighted average cost method. The calculation formula includes the cost of not only the equity of the enterprise under study, but also of the attracted (borrowed).

The enlarged method of calculating the rate

The formula in general is as follows:

WACC = Re (E / V) + Rd (D / V) (1 - tc), where:

• Re - rate of return on equity, which is own;
• E - cost equity companies in market terms;
• D is the cost of borrowed capital in market equivalent;
• V is the sum of E and D;
• Rd is the cost of borrowing;
• Tc is the current income tax rate.

Calculation of the rate of return on equity

The indicator Re, in turn, is also calculated by the formula:

Re = Rf + β (Rm - Rf), where:

• Rf - the rate at which you can get income in ways that do not require risk. Such an instrument is traditionally considered an investment in government bonds.
• β is a coefficient that shows fluctuations in the value of shares of a given enterprise relative to the market value of shares of enterprises operating in a similar segment. If the parameter is equal to unity, this means that the change in the value of the shares of a given enterprise coincides with the general changes characteristic of this segment. If the coefficient is more than one, then the increase in the stock prices of this enterprise is ahead of the competition, if less than one, on the contrary, it is behind.

The part of the formula enclosed in brackets symbolizes the market risk premium. In other words, this is the difference in returns between the stock market and government bonds. For the calculation take statistical data for a long period of time.

The disadvantage of this method is that it can only be used by those companies that, in the legal form, belong to joint-stock companies. Also, a significant amount of statistical data for a long period is required for the calculation.

Cumulative way

To calculate by this method, the following formula is used:

Discount rate = minimum rate + inflation + risk premium.

The rate of return on investments in government securities is used as the minimum rate. Risk premium - similar to the indicator that was described in the enlarged expense formula. However, there are many more ways to calculate such a premium.

Guidelines advise taking into account the risk of unreliability of partners, the risks that planned revenues will not be received at all, as well as country risk. The last indicator can be found in special tables that contain the ratings of each country, calculated by expert organizations.

So, we examined what the discount rate is. The formula for calculating it above is not the only one. We settled only on the simplest methods of calculation. The topic of researching the effectiveness of investment projects is much more complex and deeper, requires more thorough immersion in the material (which is simply impossible within the framework of one article) and long-term practice.