The discount rate is the interest rate that is used to bring future financial flows to their current value. Her calculation, perhaps, is one of the most pressing and complex issues that arises in the financial evaluation of any investment project. From its correctness depends on what final value the current cash value will have.
If you apply a low rate, then the discounted value of expected future cash receipts may be overestimated. This will entail the investor choosing an inefficient project, as a result of which he will suffer serious losses. An excessively high rate, in turn, can lead to losses that are actually - a missed opportunity to generate income.
The discount rate, therefore, is the percentage rate of return that an investor should receive on invested capital. That is, a project for an investor is considered attractive when the rate of return for him is higher than the discount rate for any other possible investment of capital having a similar risk.
The discount rate, on the other hand, is a reflection of the value of money , taking into account risks and a time factor, since real money that a person has at the moment is much more preferable (they have a high value) to the amount of money that he intends to receive in the future.
This is due to several reasons, say, that:
- there is always the risk of the estimated amount simply not to receive;
- the available amount could be profitable, say, being put on a deposit in a bank.
- the available amount as a result of inflation will lose its purchasing power.
The following parameters are included in the discount rate:
- risk ratio of investment (for each specific case);
- the minimum level of profitability that can be guaranteed.
The discount rate, the calculation of which is carried out on the basis of various methods, in practice is often determined experimentally. This takes into account both the requirements of the investor and the investment bank, attracting the funds required for the implementation of the project .
In Russian conditions, investment activity is always associated with a variable level of risk, therefore, with constantly changing levels of income and expenses. For this reason, in practice, the profitability of a project is rarely calculated using the direct capitalization method, not taking into account the discount rate.
The method of discounting financial flows, taking into account discounting, of course, much more accurately reflects the present value of income.
The most common methods for determining the discount rate of financial capital flows include the following models:
1. For your own:
- valuation of capital assets;
2. For investment:
- weighted average cost of capital.
The crucial point in the discounting process is the setting of a certain discount rate. From the point of view of the economy, the discount rate is the rate of return that could be obtained if these funds were available to the organization. Using the discount rate, they determine the amount that the investor will have to pay today in order to have the right to receive the estimated amount in the future.
The discount rate is required to:
- make a more accurate calculation of project profitability;
- compare the obtained indicators of the existing project with the lowest rate of return when investing in a similar business.