DCF Analysis: Calculating the Discount Rate 1

DCF Analysis: Calculating the Discount Rate

By Ben McClure
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Having projected the company's free cash flow for the next five years, we want to
figure out what these cash flows are worth today. That means coming up with an
appropriate discount rate which we can use to calculate the net present value (NPV) of
the cash flows.

So, how do we figure out the company's discount rate? That's a crucial question,
because a difference of just one or two percentage points in the cost of capital can
make a big difference in a company's fair value.

A wide variety of methods can be used to determine discount rates, but in most cases,
these calculations resemble art more than science. Still, it is better to be generally
correct than precisely incorrect, so it is worth your while to use a rigorous method to
estimate the discount rate.

A good strategy is to apply the concepts of the weighted average cost of capital
(WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost
of debt. (For more information, see Investors Need A Good WACC.) Therefore, we
need to look at how cost of equity and cost of debt are calculated.

Cost of Equity
Unlike debt, which the company must pay at a set rate of interest, equity does not
have a concrete price that the company must pay. But that doesn't mean that there is
no cost of equity. Equity shareholders expect to obtain a certain return on their equity
investment in a company. From the company's perspective, the equity holders'
required rate of return is a cost, because if the company does not deliver this expected
return, shareholders will simply sell their shares, causing the price to drop.

Therefore, the cost of equity is basically what it costs the company to maintain a share
price that is satisfactory (at least in theory) to investors. The most commonly accepted
method for calculating cost of equity comes from the Nobel Prize-winning capital
asset pricing model (CAPM), where:
Cost of Equity (Re) = Rf + Beta (Rm-Rf).

Let's explain what the elements of this formula are:

Rf - Risk-Free Rate - This is the amount obtained from investing in securities

considered free from credit risk, such as government bonds from developed countries.
The interest rate of U.S. Treasury bills or the long-term bond rate is frequently used as
a proxy for the risk-free rate.

ß - Beta - This measures how much a company's share price moves against the market
as a whole. A beta of one, for instance, indicates that the company moves in line with
DCF Analysis: Calculating the Discount Rate 2

the market. If the beta is in excess of one, the share is exaggerating the market's
movements; less than one means the share is more stable. Occasionally, a company
may have a negative beta (e.g. a gold mining company), which means the share price
moves in the opposite direction to the broader market. (To learn more, see Beta:
Know the Risk.)

(Rm – Rf) = Equity Market Risk Premium - The equity market risk premium
(EMRP) represents the returns investors expect, over and above the risk-free rate, to
compensate them for taking extra risk by investing in the stock market. In other
words, it is the difference between the risk-free rate and the market rate. It is a highly
contentious figure. Many commentators argue that it has gone up due to the notion
that holding shares has become riskier.

Barra and Ibbotson are valuable subscription services that offer up-to-date equity
market risk premium rates and betas for public companies.

Once the cost of equity is calculated, adjustments can be made to take account of risk
factors specific to the company, which may increase or decrease the risk profile of the
company. Such factors include the size of the company, pending lawsuits,
concentration of customer base and dependence on key employees. Adjustments are
entirely a matter of investor judgment and they vary from company to company.

Cost of Debt
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate
applied to determine the cost of debt (Rd) should be the current market rate the
company is paying on its debt. If the company is not paying market rates, an
appropriate market rate payable by the company should be estimated.

As companies benefit from the tax deductions available on interest paid, the net cost
of the debt is actually the interest paid less the tax savings resulting from the tax-
deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate
tax rate).

Finally, Capital Structure

The WACC is the weighted average of the cost of equity and the cost of debt based on
the proportion of debt and equity in the company's capital structure. The proportion of
debt is represented by D/V, a ratio comparing the company's debt to the company's
total value (equity + debt). The proportion of equity is represented by E/V, a ratio
comparing the company's equity to the company's total value (equity + debt). The
WACC is represented by the following formula: WACC = Re x E/V + Rd x (1 -
corporate tax rate) x D/V.

A company's WACC is a function of the mix between debt and equity and the cost of
that debt and equity. On the one hand, in the past few years, falling interest rates have
reduced the WACC of companies. On the other hand, corporate disasters like those at
Enron and WorldCom have increased the perceived risk of equity investments.

Be warned: the WACC formula seems easier to calculate than it really is. Rarely will
two people derive the same WACC, and even if two people do reach the same WACC,
DCF Analysis: Calculating the Discount Rate 3

all the other applied judgments and valuation methods will likely ensure that each has
a different opinion regarding the components that comprise the company's value.

Widget Company WACC

Returning to our example, let's suppose The Widget Company has a capital structure
of 40% debt and 60% equity, with a tax rate of 30%. The risk-free rate (RF) is 5%, the
beta is 1.3 and the risk premium (RP) is 8%. The WACC comes to 10.64%. So,
rounded up to the nearest percentage, the discount rate for The Widget Company
would be 11% (see Figure 1).

WACC for The Widget Company

Cost of Debt
Cost of Equity

0.40 [RF x (1-.30)] +

0.40 [5.0 x 0.7)] +

0.40 [3.5] +

1.40 +

WACC

Rounded WACC

0.60 [RF + b(RP)]

0.60 [5.0 + 1.3(8)]

0.60 [15.4]

9.24

10.64%

11%

Figure 1
DCF Analysis: Calculating the Discount Rate 4

In the next section of the tutorial, we'll do the final calculations to generate a fair
value for The Widget Company.