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Home > Cash Flow Management Checklists > Understanding the Relationship between the Discount Rate and Risk

Cash Flow Management Checklists

Understanding the Relationship between the Discount Rate and Risk


Checklist Description

This checklist describes the discount rate and how potential risks affect its calculation.

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Definition

The discount rate is the percentage by which a discounted cash flow (DCF) valuation is reduced in each time period beyond the present. Estimating a suitable discount rate is difficult and is an uncertain part of DCF. The problems are magnified by the fact that small changes in the interest rate can cause large changes in value for the final result down the line.

The discount rate used in financial calculations is commonly taken to be equal to the cost of capital. Adjustments can be made to the discount rate to take into account associated risks for uncertain cash flows. Examples of discount rates applied to various types of companies show a wide range:

Start-up companies seeking new money 50–100%
Early start-ups 40–60%
Late start-ups 30–50%
Mature companies 0–25%

High discount rates apply to more risky companies, for a number of reasons:

  • Stocks are not traded publicly, so there is a reduced market for ownership.

  • The number of willing investors is limited.

  • The risk that start-ups will fail is higher.

  • Forecasts by the business owners may be overoptimistic.

When a business has made a profit and is deciding whether to reinvest it in the business or pass it to stockholders, it must consider the discount rate. In an ideal world, reinvestment now guarantees larger profits later, and the amount of extra profit required by stockholders in the future, so that they will agree to reinvestment now, based on the stockholder’s discount rate. The capital asset pricing model (CAPM) is a way of estimating stockholders’ discount rates. These rates are usually applied by businesses to their decisions on reinvestment by calculating the net present value of the decision. If a company uses the CAPM to work out the discount rate, it must first determine the equity cash flows that are subject to this rate.

The capital asset pricing model takes three variables into account when calculating a discount rate:

Risk-free rate: This is the return (as a percentage) from investing in risk-free securities, for example government bonds.

Beta: Beta is a measurement of how the stock price of a company reacts to a change in the market. A beta figure greater than 1 means that the stock price of the company changes more than the rest of the market. A beta below 1 means that the stock price is stable and does not respond wildly to changes in the market. A beta of less than zero means that the stock price moves in the opposite direction to the market, taking leveraging effects into account.

Equity market risk premium: This is the return on investment above the risk-free rate that investors require.

The discount rate is calculated as follows:

Discount rate = Risk-free rate + Beta × Equity market risk premium

The relationship between the discount rate and risk needs to be considered when performing a DCF analysis because any adjustment of the discount rate needs to allow for risk in future cash flows, and investors need to understand the trade-off between the amount of risk and expected future returns. A higher expected return is usually accompanied by a higher risk. Risk-averse investors usually prefer to hold a risk-free asset that has an expected return that is lower than that of a risky asset. Thus the discount rate would have to rise in order to attract risk-averse investors.

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Advantages

  • Applying risk to discount rates gives a better understanding of risks and returns.

  • Considering the risk associated with a company gives an investor a better chance of understanding the risk associated with the investment.

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Disadvantages

  • Many low-level investors may not wish to consider the complexity of the relationship of discount rates to risk.

  • Becoming too concerned about risk could mean missing out on a spectacular future return.

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Action Checklist

When considering an investment, consider the position of the company:

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Dos and Don’ts

Do

  • Ensure that the risks associated with the expected returns are taken into account and understood.

  • Understand the calculations involved in determining discount rates.

  • Understand the nature of the company that is seeking inward investment—i.e. its level of maturity.

Don’t

  • Don’t ignore the risks.

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Further reading

Books:

  • Bailey, Martin J., and Michael C. Jensen. “Risk and the discount rate for public investment.” In Michael C. Jensen (ed). Studies in the Theory of Capital Markets. New York: Praeger, 1972.
  • Pannell, David J., and Steven G. M. Schilizzi (eds). Economics and the Future: Time and Discounting in Private and Public Decision Making. Cheltenham, UK: Edward Elgar Publishing, 2006.

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