Traditional Discount rate or WACC (I)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset.

For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC). It is the proportional cost of a company’s debt, determined by the after-tax interest cost, and the cost of equity, determined by a more judgment –laden but conceptually identical inquiry.

The cost of equity is conceptually identical to the cost of debt because they involve the same question:

• What must the company pay to induce investment, whether from debt lenders or equity holders?

The cost-of-equity exercise is more judgment-laden than the cost-of-debt exercise because there are no maturity dates or set coupons on equity (dividends are payable solely in the corporate board’s discretion).

The key reference is what other capital market participants are paying investors to attract equity financing form enterprises of comparable risk.

• To estimate the cost of equity capital for high-risk venture capital projects, for example, one could consult the returns offered by venture capitalists in such enterprises.
• For low-risk enterprises, underwritten secondary public offerings of blue-chip companies can be examined.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Risk-free rate

VALUE INVESTING APPROACH TO RISK AND RATES

The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.

The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.

Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.

Selecting a risk-free rate requires judgment based on various factors. Such factors include:

• bond maturity,
• reference date or time frame, and
• reference source.

Possible sources include the rate disclose in the company’s own public filings. This is a non-arbitrary choice, reflecting the rate the company uses for its internal purposes and considered sufficiently material to disclose in its public filings.

Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.

When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).


Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary