Choosing an appropriate discount rate (or cost of capital) is necessary to determine present value, whether measured by current earnings or a more elaborate discounted cash flow model.
The discount rate must reflect
- the time value of money and
- the specific risks associated with te individual company.
Equity is riskier than debt, so the discount rate for a given company will be some increment above the prevailing rates at which any debt it has outstanding are being discounted. The challenge is determining how much greater.
Conceptually, think of the discount rate as the rate of return a prudent investor would require for allocating capital to the subject company
A high-risk venture would warrant a proportionately high discount rate; a sure thing, a rate probably equal to the time value of money.
The surest investments in contemporary investing are U.S. government securities. These furnish the risk-free rate.
Appropriate discount rates for most corporate equity will take U.S. government securities as the starting point and add an additional element.
Considered below are two alternative conceptual approaches to thinking about and settling upon an appropriate discount rate,
- one traditional and
- one from modern finance theory.
Also read:
No comments:
Post a Comment