The discount rate is an outcome expressed as a percentage that reflects the present value of future cash flows. The value of money at this moment decreases in the future, and in that respect, there is a certain time value of money. Inflation causes the future value of money to be lower than the current value. For example, with 100 euros now, you get more value for your money than in a year because prices are rising. Calculating the discount rate is important not only for companies but also for investors. They prefer to have money now to make it yield rather than in a year, as they would miss out on returns.
Why calculate the discount rate?
Due to future expectations, companies use the discount rate to calculate the company’s value. A calculation tool in the form of Weighted Average Cost of Capital (WACC) can be used for this. For a future value calculation, just like for the present value, the discount rate is a mandatory component. Banks and financiers use the outcome of the percentage as an aspect of the assessment to decide whether or not to invest.
In practice, companies use the percentage to calculate the return on various business components, such as inventory, capital, and other investments. When deciding to invest, a company may need a certain percentage of the discount rate to achieve the break-even point with the purchase. If the percentage is lower, there is an opportunity to change the production process. There are several reasons why the discount rate is important:
What is the relationship between cash flow and discount rate?
Discounted Cash Flow, abbreviated to DCF, is used by companies to arrive at the discounted cash flow. This involves correcting the financial value of money concerning the time influence, where the quality of a potential investment can be determined. The cash flow is important in every company, among other things, because the cash flow indicates how the company is doing. For example, concerning the ability to meet outstanding invoices in the short term.
Investors also find a company’s cash flow important to determine the credit risk. Moreover, as an entrepreneur, it is also important to know what the cash flow position is. In the case of negative cash flow, it is possible to take measures, such as efficiently performing accounts receivable management. In cash flow calculation, there is an assessment of outgoing and incoming cash flows.
Estimating the value of an investment
The discount rate is an important component of the DCF method, as it allows the value of an investment to be estimated based on expected future cash flows. The time value of money plays a crucial role in this, and in this method, the discount rate is used to discount future cash flows. The outcome shows whether a project is attractive to undertake and/or if it is viable.
Calculating the present value of future cash flows is done using the discount rate. For the calculations of the discount rate, it is important to look at the amount to be invested. Then an assessment is made of the return on the investment in the future. It is possible to see what the investment yields annually in cash flow.
Profitable project with positive net present value
The net present value can be calculated by subtracting the discounted cash flows from the original investment. With a positive outcome, it can be stated that there is a profitable and attractive investment. It is useful to get a concrete picture of the discount rate using an example based on the DCF method.
Discount rate example
When planning to make an investment with the goal of realizing a certain amount of free cash flow in the future, the present value or discounted value of the relevant future cash flows is important. If there is a required return of 10% and the additional desired free future cash flow is €100,000, then the discount rate is 10%. The present value decreases further each year, and as a result, cash flows that are further in the future have much less value or no present value at all.
Increasing impact of the discount rate
The discount rate has an increasing impact as the years progress. The further into the future money is earned, the lower its present value is. If the cash flow is the same annually, the present value becomes lower. When the discount rate exceeds the growth rate of the cash flows, there is a further decrease in the present value of cash flows.
