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discount rate

Page history last edited by PBworks 15 years, 8 months ago

Discount rate

 

 

The process of calculating the net present value of a future cash flow is called "discounting"

 

The discount rate which is used in financial calculations is usually chosen to be equal to the cost of capital . Some adjustment may be made to the discount rate to take account of risks associated with uncertain cash flows, with other developments.

 

 

 

Appropriate Discount rates to use:

 

If the project is about as risky as the stock market as a whole, then use the traditional return of stock market as the cost of capital. This is because an investor could take their dividends and invest them in the stock market, so the appropriate discount rate is the "opportunity cost" that they could get in the stock market. You then have to compare the risk of that project to the risk of the market as a whole. This is subjective, but there are techniques to gauge this riskiness vs. the stock market (equity beta coefficient for example).

 

 

The discount rates typically applied to different types of companies show significant differences:

 

Startups seeking money: 50 – 100 %

Early Startups: 40 – 60 %

Late Startups: 30 – 50%

Mature Companies: 10 – 25%

 

 

 

 

 

 

Reason for high discount rates for startups:

1. Reduced marketability of ownerships because stocks are not traded publicly

2. Limited number of investors willing to invest

3. Startups face high risks

4. Over optimistic forecasts by enthusiastic founders.

 

 

 

 

 

 

 

Weighted Average cost of Capital (WACC)

http://formularium.org/en/___go/96/10.html

 

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. It has been used by many firms in the past as a discount rate for financed projects, since the cost of the financing seems like a logical price tag to put on it.

 

Corporations raise money from two main sources: equity and debt. Thus the capital structure of a firm comprises three main components: preferred equity, common equity and debt (typically bonds and notes). The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a firm.

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