Calculate Discount Rate
Calculate Discount Rate
The rate at which future cash flows and terminal value are discounted is known as Discount Rate. In other words, it is minimum required rate of return of investors. If it is FCFF model then the Discount rate us Cost of Capital (Also known WACC) and if it is FCFE model then the discount rate is Cost of Equity:
Cost of Capital (WACC, Ko): Minimum weighted average required rate of return of all investors in the Firm (Includes Debt, common Equity and Preferred Equity) is known as WACC.
Formula for WACC calculation:
WACC = Ke*We + Kd*(1-Tax rate)*Wd + KPs*WPs
Where Ke = Cost of equity and We = Weight of equity
Kd = Cost of debt and Wd = Weight of debt
KPs = Cost of Preferred equity and WPs = Weight of Preferred stock
Cost of Equity (Ke): Minimum Required rate of return of common equity
Capital Asset Pricing Model (CAPM) is most popular model of Cost of equity calculation.
Formula: Rf + Beta * (Rm – Rf)
Where Rf represents Risk Free rate
Rm represents Market Return
Beta: Beta shows the riskiness of the stock with respect to all market index.
If Beta is 2, then it shows that if market goes up by 10% then individual stock will go up by 20% and market goes down by 10% then individual stock will go down by 20%.
Risk Free Rate: 1. Take Risk Free Rate of bond of central Govt. where parent company is listed
- Maturity period of bond should be equal to forecast period in DCF
Risk Premium (Rm-Rf): Risk Premium is generally an assumption of analyst. But sometimes, Risk Premium is taken from Historical returns also which is not recommended because WACC will be used to discount future cash flows and so we have to think of minimum expected return in future. So generally Risk Premium is from 3% to 9% which is a direct assumption taken in DCF valuation.
Many times Beta is directly taken from Bloomberg or some other sources, but that beta is historical beta and may be manipulated also and may not reflect the true riskiness of stock and if it is private company then Beta will not be available at all.
So in all these cases, it is suggested to recalculate beta based of Industry average fundamentals. So you first take few comparable companies and find out the Unlevered Beta of those companies and take the average Beta and that Unlevered Beta is used to calculate Levered Beta of company in valuation.
Beta Unlevered = Beta Levered
1 + D/E*(1 – tax rate)
Beta Levered = Beta Unlevered * ( 1- D/E*(1 – Tax Rate)
Cost of Preferred Stock (KPs): Minimum Required rate of return of preferred equity. Cost of preferred stock is Dividend Rate on Preferred Stock. If there are multiple Preferred Stock with different Dividend rate then the Cost of preferred stock is weighted average of preferred dividend rates.
The above article is just to give you a basic overview of WACC but there are many more related concepts you need to know to calculate WACC accurately. To know more about it, you can refer to our question bank or FAQs on company valuations.
Article by Manoj Kumar: Senior Trainer with IB Institute
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