3.2 What is the Discount Rate Anyway?
In our discussions regarding Capital Budgeting Methods, we have, so far, assumed a given Discount Rate, “R.” It was provided without explanation. In this chapter, we will learn how to calculate R and how to apply it. We will also examine some nuances.
First, let’s recall how R was used in Capital Budgeting. In each of the following methods, it was used as a Discount Rate:
- Discounted Payback Method
- Net Present Value
- Profitability Index
- Replacement Chain Analysis
- Annual Annuity Approach
You will note that the Simple Payback Method is absent from this list.
Next, in the following methods, R was used as a Hurdle Rate.
- Internal Rate of Return
- Modified Internal Rate of Return
The rule of thumb for the two methods above require that the calculated rate must exceed the hurdle rate in order for an independent project to be “accepted.”
To calculate the Discount Rate, we will first identify the four Capital Components which a firm may acquire so that it may finance the acquisition and maintenance of its assets:
- Debt
- Preferred Equity
- Common Equity
- Retained Earnings
You will note that only Retained Earnings is an internal capital source; the other components must be obtained externally. Each component will have its own economic cost, which will be calculated. Once that is done, we will calculate the Weighted Average Cost of Capital – “WACC” – for all four components combined. The WACC will serve as our discount and hurdle rates.
Finally, you will recall that the Free Cash Flow projections we imported into our Capital Budgeting templates excluded capital costs. Here – finally – we utilize it, not as a dollar amount, but as a rate.