Discount Rate
The discount rate which is used in financial calculations is usually chosen to be equal to the Cost of Capital. The Cost of Capital, in a financial market equilibrium, will be the same as the Market Rate of Return on the financial asset mixture the firm uses to finance capital investment. Some adjustment may be made to the discount rate to take account of risks associated with uncertain cash flows, with other developments.
The discount rates typically applied to different types of companies show significant differences:
- Startups seeking money: 50 – 100%
- Early Startups: 40 – 60%
- Late Startups: 30 – 50%
- Mature Companies: 10 – 25%
The higher discount rate for startups reflects the various disadvantages they face, compared to established companies:
- Reduced marketability of ownerships because stocks are not traded publicly.
- Limited number of investors willing to invest.
- Startups face high risks.
- Over optimistic forecasts by enthusiastic founders.
One method that looks into a correct discount rate is the capital asset pricing model. This model takes in account three variables that make up the discount rate:
1. Risk Free Rate: The percentage of return generated by investing in risk free securities such as government bonds.
2. Beta: The measurement of how a company’s stock price reacts to a change in the market. A beta higher than 1 means that a change in share price is exaggerated compared to the rest of shares in the same market. A beta less than 1 means that the share is stable and not very responsive to changes in the market. Less than 0 means that a share is moving in the opposite of the market change.
3. Equity Market Risk Premium: The return on investment that investors require above the risk free rate.
Discount rate= risk free rate + beta*(equity market risk premium)
Read more about this topic: Discounting
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