![]() We describe the development of an equity discount rate with a description of each component below. How to Build Up a Discount Rateīefore we delve into what is reasonable and what is not, one must first understand the components of a discount rate as these help the attorney understand how an appraiser estimates this rate. Intuitively, this explains why the cost of equity, or “discount rate,” is higher than the cost of debt, or interest rate. Because equity investors come last, they require the highest rate of return in order to provide equity capital to a business. After generating revenue, paying expenses and taxes, and reinvesting funds needed in the business, any remaining cash flow is shared by the equity investors. Debt capital providers are paid before equity capital providers, typically at a fixed or floating interest rate (for example, a company’s line of credit could be 4.0% fixed rate or vary, such as 1% over the prime rate). Returns to an equity investor come after all other parties have been paid. The discount rate goes by many names including “equity discount rate,” “return on investment,” “cost of capital,” and “rate of return.” For companies that use debt, the appropriate way to discount cashflows may be the weighted average cost of capital, or “WACC.” Thinking about a discount rate as a rate of return is likely the most intuitive approach. As we have all heard, “a dollar today is better than a dollar tomorrow.” Measuring the present value of future earnings allows us to develop a value for a business today. The discount rate “discounts” future cash flows to a present value. Now, if the future cash flows are less certain, they are deemed to be riskier, which reduces the value of the business. ![]() Each of these statements makes perfect sense. What Is a Discount Rate?Ĭompanies with larger cash flows are likely to be more valuable, as are those with cash flows that are growing at a faster rate. Then, we will relate the discount rate to rates of return of other investments that should provide a commonsense road map for what is reasonable and what is not. In this article, we will examine the various components of a discount rate. ![]() There are several generally accepted methodologies to build up discount rates employed by valuation analysts. In valuations that “feel” too high or too low, one of the potential culprits may be an aggressive discount rate, either on the high or low end.
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